Written By Ryan Farias, Senior Portfolio Manager

When most people hear “ETF,” their first thought is usually “Index Fund.” For years, ETFs (Exchange-Traded Funds) have been synonymous with low-cost, passive investing. We love passive indexing, and we were early adopters of ETF’s as building blocks for portfolios. However, the reality of the ETF market today is far more complex and diverse as new fund offerings have become prolific. While the traditional index-tracking ETFs remain a staple, the industry has expanded significantly, introducing products that go far beyond simple market replication.

As a matter of fact, one could argue that Wall Street has once again intervened in ways to corrupt the fund market with its own creations. One of the world’s leading fishing lure companies is Rapala. A Finnish fisherman named Lauri Rapala formed the company in 1936, and he was famous for a quote whereby he said that surely his lures catch fish, but “more importantly they catch fishermen”. Wall Street is also adept at creating vehicles to attract investors despite their poor history of those products creating results.

Understanding Indexing and Its Role

To appreciate the foundations of ETFs, it’s essential to understand what indexing seeks to achieve. We can view the CRSP US Total Market Index as the dollar-weighted average of investor returns. This means that for every dollar of return in excess of the market average return, there is a corresponding dollar that lags behind the index. This principle holds true over any time horizon and for all investors collectively.

The implication? Generating Alpha (excess returns above the market average) is inherently a zero-sum game. While individual investors or funds may outperform, they do so at the expense of others who underperform. Importantly, though, the market itself is not a zero-sum game. Over time, companies create value through profitable investments and innovation, driving consistent profit growth and, in turn, supporting the upward trend of markets.

Index funds aim to capture this broad market growth by replicating the performance of an index like the CRSP US Total Market Index. These funds don’t attempt to “beat the market”; instead, they provide investors with exposure to the entire market at a minimal cost, making them an attractive option for many.

The Evolving ETF Landscape

While indexing remains the foundation of many ETFs, the ETF industry has evolved to offer far more than basic market replication. Index-tracking ETFs, such as those replicating the S&P 500 or the CRSP US Total Market Index, dominate the market in terms of assets. These funds are highly efficient, charging fees as low as 0.02% annually.

However, to differentiate themselves and generate higher fees, ETF managers have increasingly moved beyond traditional indexing. Many now offer niche products or actively managed ETFs designed to outperform the market or cater to specific investor interests. This diversity provides investors with more options but also introduces complexity and higher costs.

The Odds of Outperformance

To understand the challenges of picking the right ETF, let’s look at the numbers. We analyzed a universe of 749 ETFs that invest in U.S. equities, with at least five years of performance history. The results were eye-opening: only 19% of these ETFs outperformed the broad U.S. equity market (as measured by the CRSP US Total Market Index).

Over the past five years, the average return for these ETFs was 9.91%, compared to 13.83% for the benchmark. And these funds came at a higher cost, charging an average annual fee of 0.40%.

So, if you’re picking ETFs, you’re starting with an inherent disadvantage: many funds underperform both their benchmarks and the broad market once fees are accounted for. Even more interestingly, on average, ETFs have underperformed the average mutual fund net of fees (but before taxes). This underperformance is largely driven by specialized funds, such as those focused on Cannabis, Biotech, and Clean Energy, which have seen negative returns over this period.

Note: Analysis based on 5-year period ending 12/31/2024 Source: Segment, Morningstar, Schwab

Taxes: A Hidden Advantage of ETFs

One of the strongest advantages of ETFs—particularly compared to mutual funds—is their tax efficiency. ETFs use a mechanism called the in-kind creation and redemption process, which allows managers to swap securities without triggering taxable events for investors. This feature minimizes capital gains distributions and helps investors keep more of their returns.

In contrast, actively managed mutual funds are notorious for being tax inefficient. Not only do they often underperform their benchmarks after fees, but taxes on their distributions eat further into returns. According to a S&P Global SPIVA study, over the 10 years ending December 2023, actively managed mutual funds delivered an average annual return of 8.67% after fees, which dropped to just 6.68% after taxes on distributions (pre-liquidation). By comparison, the index returned 11.35% after taxes (pre-liquidation), highlighting the compounding drag that taxes, fees and alpha seeking can impose.

The Takeaway: Stick to the Basics

Given the complexities and risks of selecting niche or actively managed ETFs, the best approach for most investors is focusing on broad-market index funds with the most passive management strategies and the lowest fees.

ETFs have revolutionized investing by providing easy access to markets at a low cost, but they are not immune to the challenges of underperformance and higher costs when straying from the core principles of indexing. By keeping things simple—investing in funds that replicate the broadest indexes—you can maximize your chances of capturing the market’s long-term growth while minimizing unnecessary fees and taxes.

Please see IMPORTANT DISCLOSURE information.