This article is part of ourBest ETFs for 2012series, in which we're seeking out the top-performing ETFs for the coming year.
Here's a sad statistic: Two-thirds of actively managed stock funds have underperformed the S&P 500 over the past three years, according to Standard & Poor's.
That wasn't an anomaly, either. According to the Vanguard Group, "When removing the effects of survivorship bias, the percentage of funds that underperformed the market [was] 62% for the 10-year period, 67% for the 15-year period, and 72% for the 20-year period."
The vast majority of professional investors fail to do better than their benchmark.
The trend is getting worse, too. In recent years, "the percentage of funds that have underperformed the broad market has increased substantially," Vanguard says.
This shouldn't be surprising. With over $12 trillion in worldwide equity mutual funds, it's impossible for most actively managed funds to outperform the market -- they effectively are the market. The same is true for private hedge funds. Stacked with Ph.D.s and powered by some of the most sophisticated algorithms in the world, hedge funds have become, on average, high-cost index funds. The HFRI Equity Hedge Fund Index -- a broad collection of global hedge funds -- has now underperformed the S&P 500 over the past five years.
Make no mistake: Smart investors can still outperform the market, particularly those with patience and discipline. Several Motley Fool newsletters have bested their benchmarks over multiyear periods -- substantially, too.
But for those of you who don't want to bother rolling up your sleeves and digging through individual companies, a broad index fund like Vanguard's Total Stock Market ETF (NYS: VTI) is a smart choice for long-term investors.
The Total Stock Market Index owns a tiny bit of just about everything -- 3,313 companies, to be exact. The fund's distribution is fairly disperse, but still weighted toward the largest names. ExxonMobil (NYS: XOM) and Apple (NAS: AAPL) alone account for more than 5% of the fund's assets. Add in the rest of the top five holdings, including IBM (NYS: IBM) , Microsoft (NAS: MSFT) , and Chevron (NYS: CVX) , and just 0.15% of the fund's stock choices represent about 10% of the fund's investment. Its goal is not to beat the market; it aims to be the market, while charging the absolute lowest management fees.
The rationale is simple. The total return earned by equity investors in aggregate in any given year is whatever the market generates, minus management fees and transaction costs. Vanguard founder John Bogle calls that "the relentless rule of humble arithmetic," and its implications are important:
Over half of all investors must underperform the market average, since fees subtract from the aggregate market return.
Thus, you can do a little bit better than the average investor by being the market average and keeping your fees as low as possible.
Being a hair above average isn't half bad, either. Since 1992, the mutual fund equivalent of the Total Stock Market Index ETF has produced an average annual return of 7.55% per year, turning $10,000 into $37,000.
To really lock in the beauty of indexing, there's something else investors must remember. Consider: From 1983 through 2003, the market rose 13%, the average actively managed fund rose 10%, yet the average investor earned 6.3%, according to Bogle.
Why? Because the average investor piled in while the market was on an upswing, and sold when it was at or near a trough. Even in an index fund, buying high and selling low can -- and does -- leave most investors with below-average returns.
There is, however, an easy fix: dollar-cost averaging, or purchasing an equal dollar amount of stock every month or every quarter, come rain or shine, bull market or bear.
Dollar-cost averaging in a broad-index ETF doesn't guarantee you'll make money over time. It doesn't guarantee a comfortable retirement, college for your kids, or a spot on the Forbes list of billionaires. But it guarantees that you'll own a slice of the global economy, purchased at an average price that is impervious to market volatility, and with a rock-bottom management fee. It also guarantees -- a mathematical certainty, in fact -- that you will do better than a slight majority of investors over time. That's the beauty of indexing.
Is it for you? Let me know in the comments section below.
Stay tuned throughout our series on the Best ETFs for 2012 to find out about all of the picks our Foolish contributors have made.Click back to the series introfor links to the entire series.
At the time thisarticle was published Fool contributorMorgan Houselowns shares of Microsoft, Exxon, and Chevron. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of IBM, Microsoft, and Apple. Motley Fool newsletter services have recommended buying shares of Apple, Chevron, and Microsoft, as well as creating bull call spread positions on Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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