Did you know that exchange-traded funds (ETFs) can give you all the benefits of investing, with almost none of the work?
Making credible investments in individual stocks is a notoriously difficult endeavour. A predictable 95% of active fund managers fail to beat the S&P 500 over a 15–20 year period. Those who have outperformed consistently, such as Warren Buffett and Charlie Munger, note the extreme amounts of research they put into their investments.
So if you don’t do it full time, and with extraordinary discipline, picking stocks is unlikely to work out for you.
Fortunately, you don’t have to pick stocks to invest in them. You can invest in exchange traded funds (ETFs) instead. ETFs are diversified stock portfolios that trade on the market like stocks themselves. They’re much like investment funds managed by professional stock pickers, but they track indexes, so they don’t incur large management fees. As a result, they tend to produce higher after-fee returns than active funds. In this article, I’ll explore the power of ETFs to increase your portfolio returns.
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Why picking individual stocks is so hard
The main reason why ETFs are comparatively effective is that picking individual stocks successfully is extraordinarily difficult. The efficient market hypothesis posits that stock prices reflect all known information relevant to the companies they represent. In other words, the current price is the “right” one, and the future trajectory of a stock is basically unknowable.
Now, stocks as a group do have a tendency to go up over time. But the rise is driven by a tiny handful of stocks in the universe: a randomly chosen stock from the all-world index would likely underperform Treasuries. So, buying the market is likely to work out better than trying to pick stocks. To pick stocks successfully and consistently requires an information edge, which is definitionally hard to obtain.
This is the magic of ETFs: they give you a shortcut to buying the entire stock market. Instead of forcing you to sit down reading annual reports, testing out products and talking to company insiders, they let the broad market work its magic for you. And, because they track published indexes, their fees tend to be low.
A fund that gives you a shortcut to returns
One Canadian ETF that many investors consider good is the iShares S&P/TSX Capped Composite Index Fund (TSX: XIC). It tracks the TSX Composite Index, which is the 240 largest publicly traded companies in Canada. XIC actually holds 220 of the 240, so it tracks its index pretty well. Finally, XIC is one of the most liquid and widely traded funds in Canada, so it has a very narrow bid-ask spread. A “bid-ask spread” is the difference between what sellers ask and buyers bid. Market makers pocket this spread as a hidden fee, so a narrow spread saves you money.
Foolish takeaway
Taking into account decades of academic research, it appears that ETFs are the best wealth-building vehicle for most people. The kind of information edge that makes stock picking workable is tough to acquire. So you’re likely better off with ETFs than individual stocks. If you’re looking for a place to get started with ETF investing, XIC is probably a decent one.
