MW Here's the downside of index funds and ETFs

By Brett Arends

New report challenges conventional wisdom

Wait, what?

Based on the conventional wisdom in the financial-planning industry and in financial media, you'd think the new world of low-cost exchange-traded funds and index funds is a straightforward win-win for the average investor.

The reality? Not so fast.

So reveals a new report from Morningstar, the investing and fund-analysis company. It finds that over the past decade, in many instances, investors in traditional, old-fashioned mutual funds have made more money than investors in modern ETFs, and that investors in higher-fee "actively managed" funds, where a professional fund manager picks individual stocks or bonds, have made more money than those who stuck to low-cost index funds.

That was true, for example, for the average investor in regular U.S. bond funds, in tax-free municipal bond funds and in international stock funds, Morningstar found.

The reason? Pretty simple, really. It's what the fund industry calls "stickiness." Those who entrusted their money to traditional mutual funds were much less likely to try to trade in and out than those who owned ETFs, and the same went for those who entrusted their money to actively managed funds as opposed to those who went for index funds.

So, for example, those who invested in actively managed taxable bond funds ended up earning an average of 1.4% a year over the 10 years through the end of last year, Morningstar reports. Those who invested in indexed taxable bond funds? Just 0.8% a year.

Those who invested in actively managed municipal bond funds earned an average of 1% a year. Those who owned indexed municipal bond funds earned 0.7% a year.

And those who invested in actively managed international stock funds earned an average of 5.2% a year - a full percentage point ahead of the 4.2% earned on average by those who invested in indexed international stock funds.

The gaps were similar when Morningstar compared returns from traditional open-ended funds to those from exchange-traded funds, which makes sense because to a large extent you're measuring the same thing. Most actively managed funds are also traditional open-ended funds, where you effectively buy units directly from the fund company and investment takes place once a day. ETFs, where you buy your fund units through trading on the stock market and you can trade throughout the day, are more likely to be low-cost index funds.

None of this is a simple endorsement of higher-fee active fund management. In each category, from U.S. stocks to international stocks, from bonds funds to balanced and allocation funds, the average low-fee index fund itself beat the average higher-fee active fund. That is actually inevitable, because ultimately it's a zero-sum game before fees. But as Morningstar's annual "Mind the Gap" report reminds us, the average returns of a fund are not the average returns of its average investor. That's because investors have a terrible tendency to buy high and sell low. They jump onto a boom only after it's been going for some time and prices have already risen a long way, and they bail after it has crashed.

Overall, Morningstar says the average U.S. fund investor earned 7% a year over the past decade (through Dec. 31, 2024), while the underlying funds earned 8.2%. "That 1.2 percentage point 'investor return gap,' which is explained by the timing and magnitude of investors' purchases and sales of fund shares during the 10-year period, is equivalent to around 15% of the funds' aggregate total return," says Jeffrey Ptak, managing director at Morningstar.

To put this in context: If you blow 15% of your total returns per decade by buying high and selling low, over the course of 40 years you will end up blowing almost half - 48% - of the money you would have made just by buying and holding.

Or to put it another way, you'll retire with half the money you would have had. Enjoy!

Intriguingly, most of these losses over the past decade were in the bond market. Investors poured money into bonds, especially near the end of the giant bull market in 2020 and early 2021, Ptak tells me. Then they bailed when bonds began to collapse.

But investors also left huge amounts of money on the table by buying and selling international stock funds and U.S. sector stock funds at the wrong time. Overall they earned an average of 4.8% a year from international stock funds, while just buying and holding would have made them 5.9% a year. And they earned 7% from U.S. sector stock funds, such as technology or energy stock funds, while buying and holding would have earned 8.5%. Ouch.

Investors fared much better overall when it came to straight U.S. stock funds, Morningstar reports. The average investor in these funds earned an average annual return of 11.1%, the firm reports. (That was still about 0.6 percentage points a year less than they would have earned from a simple buy-and-hold strategy.) They did best among big-cap funds, and especially big-cap "blend" funds, meaning things like the SPDR S&P 500 ETF SPY. When it came to those, the average investor made 12.2% a year, slightly ahead of the 12.1% they would have made by simply buying and holding.

And the average investor left less money on the table when it came to boring "allocation" funds, such as balanced stock and bond funds and target-date funds. The gap between what investors actually earned and what they would have earned through a buy and hold strategy was just 0.1 percentage points a year.

What does this mean for investors looking forward?

The easy answer would be to encourage everyone to give up trying to time the market. Yes, if you buy low-cost index funds and just hold them you will almost certainly make more money than those who try to trade. Trying to time the market will probably cost you money. The main benefit of open-ended funds and active funds was that the people who owned them were less likely to trade.

This is the answer we hear over and over again from the index-fund "efficient market" crowd, and it's not completely wrong. But it's only half an answer. It doesn't really tell us which index funds to own.

U.S. large-cap stocks? Small caps? International? Emerging markets? Bonds?

Simply extrapolating from the past 10 years to the next 10 years would be like trying to drive a car by looking in the rear view mirror. Yes, U.S. large-cap stocks have been on a massive tear since the global financial crisis in 2009. But so what? The last time people were saying "Oh, the only thing you need is the S&P 500 SPX, or maybe the S&P 500 and the Nasdaq Composite COMP," was at the tail end of a similar boom, around 1999-2000. It turned out to be disastrous advice. Over the next decade or so, those indexes cost you money. You were much better off owning bonds, international stocks and emerging markets.

So: Whichever asset class ends up outperforming over the next 10 years, I'm willing to bet that owning that asset class through a low-cost index fund, and just buying it and holding it, will be a terrific investment strategy. But we won't know which asset class that will be until, oh, around 2035.

Meanwhile, news that the average investor loses money through market timing means that somebody else is making money by taking the other side of the trade. It is very hard to avoid the conclusion that if you really want to trade, you are typically better off buying when everyone else seems to be bearish and selling, and selling when everyone else seems to be bullish and buying. This is the rationale behind this column's occasional feature, Pariah Capital.

Some people in the efficient-market crowd get angry when I point this out, but they have never explained why it's wrong.

-Brett Arends

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August 20, 2025 11:26 ET (15:26 GMT)

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