Many years ago, if you wanted to build a stock portfolio to invest your savings, you only had these choices: doing it manually, selecting stocks that you prefer or following a financial advisor, your intuition, or a newspaper, or you could invest in mutual funds that would have done the entire job for you.
Mutual funds are extremely expensive in terms of commissions, and most of the time, they have been unable to do better than their benchmark index.
Investing and disinvesting could also take a couple of days. I remember the anxiety I felt when the stock market went down a lot. I had to wait almost 48 hours before seeing what had happened to my money.
I remember that, in the early 2000s, I had started investing in emerging markets.
Buying those stocks, like Indian or Brazilian, for me, in Italy, almost 20 years ago, was just technically impossible. A mutual fund was the only choice available.
Things have since changed. While the mobile phone market was disrupted and changed by the first iPhone, in the investment world, something equally disruptive had just happened: the invention of ETFs.
I was in my early twenties, and I could not believe that, finally, I could invest in a whole stock market index, in real time, paying negligible commissions.
It seemed too good to be true…but it was actually true!
At the beginning, there was not enough variety in this new offer, but it was possible to invest passively on the stock representing all the major stock indexes.
Mutual funds were still necessary to invest in specific financial sectors, like biotech and healthcare.
Before this big change in the investment world, you had to have enough savings to be an interesting client for your bank. The first thing that your private banker or financial advisor would have told you to take care of your savings is that you should invest in a fund branded by a big investment company. They would also try to persuade you that, by doing so, some extremely skilled analyst selecting the stocks would do a much better job than you.
The bank employee was wrong; in fact, if you selected a number of stocks at random, big enough to be statistically representative of the benchmark index, any investor would have achieved similar results to most of the big financial firms.
The reasons why this is possible are many, and the topic is still open to debate. If you are curious, keep visiting this website, as I will soon publish an article about it.
In practice, though, an investor who was not passionate about finance would have encountered many little, but altogether significant, technical problems while executing his “random investment plan.”
For example, he might not have understood how to place an order on illiquid stocks, how and when to reinvest dividends, and deal with stock split and buyback. Those are all little things. But altogether, they could have been an obstacle big enough for most investors to go back to the bank and ask them to do the job for you. Especially if you were not a finance enthusiast.
If you had enough money, you could go to the wealth management department, where people with knowledge hopefully proportionate to your wealth would have take care of your money. The only things that were actually scaled to your wealth, however, were the management fees.
When you walked into the local bank (or wealth management firm, if you had more money), a big chunk of the commission paid to the fund would go to the bank—directly to the employee who convinced you to invest there.
If ETFs were the iPhone, mutual funds were Nokia.
In 2007, you did not need to be an engineer to understand that the iPhone was a leap ahead into the future. I was in a store in San Diego when I first touched, in a Apple store, the first iPhone. When I controlled it by touching the screen, I felt physically that it was superior to everything that was on the market at that time.
Those are some of the reasons why Nokia has disappeared, but there are still mutual funds around.
An ETF in the early 2000 was, for investment purposes, superior to a mutual fund, just as much as the new Apple iPhone was better than anything else. But you cannot touch or interact with an ETF in the same way as you do with a smartphone!
Therefore, the superiority, of an ETF can be measured on an Excel spreadsheet, and it is not self-evident for those who are not financially educated.
Investing in a fund that buys American stocks comes with a fee of 0.7% minimum. 15 years ago, it was at least double that, so the yearly cost of an ETF is negligible.
What do you think the bank employee would have told me at 22 if I expressed my desire to invest in the ETFs ?
The first, standard, corporate answer was: how can a passive instrument be better than a team of bankers making investment decisions?
Data proves that investing actively in the stock market is very hard to do better than investing passively on a stock index.
Knowing the reason would not change the facts.
There are still some cases where a mutual fund, especially in the case of a very specific investment, could do better than an ETF, and also, there are few fund managers who are able to beat their benchmark.
It is not easy to say whether searching for the few funds that still represent an investment opportunity is worth it or not.
It is important to remember that even if the fund manager was really skilled and able to generate alpha, while managing a big, multi-billion-euro fund, he will incur huge transaction costs. And after subtracting fees, commission, and salaries for his co-workers, the likelihood of his final return being higher than the benchmark index becomes lower.
If you like ETFs, keep visiting this website. Soon I will write more articles about that.