You can beat an index ETF

That's right, you can beat an index ETF by stock picking. We all know the stories of our friends, family or neighbors who scored big time with their investment. They invested all their money in Apple or Tesla and made a killing on their investment. And here we are, investing in an index ETF with decent but slow results.

But have you ever thought about the other side of the coin? Where there are winners, there are also losers. We typically do not hear (or ignore) the stories of people losing a lot or even all of their money. We also do not follow up after 5 years with the same person to see if he still outperforms the market or if it was a lucky shot.

Active vs Passive investing

Our neighbor above has dabbled in active investing. Which means that he bought certain assets which he thinks will perform very good. And he will sell them again when they will stop performing. The same principle is done on a bigger scale by actively managed funds. They will chose a basket (fund) of assets for you (for a small fee). They of course expect that their fund will outperform passive index ETF's.

A passive index ETF is typically an ETF that copies a market index. A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. The calculation of the index value comes from the prices of the underlying holdings. Some indexes have values based on market-cap weighting, revenue-weighting, float-weighting, and fundamental-weighting. Weighting is a method of determining how much of each company should be bought for the fund. The passive index ETF will not try to beat the market. They will try to match the performance of the market. The costs of the passive index ETF are typically lower than an active fund because the fund manager does not need to spend time on choosing the right assets, They just copy the index.

What's best?

Which brings us to the main point of this post. A lot of research shows that most active managed funds do not outperform a broad market index. For example, if we look at the data from Spiva, one out four actively managed funds do not outperform the S&P Europe 350 index over a period of 5 year.

Note that how longer the investment horizon is (1 vs 3 vs 5 years), the less likely it is that the actively managed funds will outperform the index ETF. Almost 86% of the active funds underperformed the index over a 10 year period (source).

To come back to our neighbor

As seen above, most active fund managers cannot outperform said stock market over a long term. And it's their full time job to follow the stock market. So what's more likely? Our neighbor being a natural investment guru? Or our neighbor just being lucky and choosing one asset which happened to skyrocket? His good performance is most likely a reward from taking a risk and investing in 1 or a limited amount of shares. To put it simply:

• You can get decent returns with a broadly diversified ETF.

• Yes, you can get get better results by zooming in on a sector (FAANG) or region (S&P500).

• Yes, you can even get even better results by zooming in on single share (Apple).

• Yes, you can even get stellar result by zooming in on speculative share (Gamestop)

However, if you zoom in, the risk of bad results also increase. You might make a killing 1 year, 2 years or even 5 years in a row. But can you keep picking the winners in the market 10 years in a row? Now in reverse order:

• You lost a lot of money if you only bought Gamestop at the top (to do the squeeze).

• You lost a lot of money if you only bought: "Lernout & Hauspie; Nyrstar; Fortis; Lehman Brothers, Blockbuster, General Motors, etc...

• You can wait for decades for a positive return if you only invested in Japan in the 90's. See the lost decade for more information about the Japanese economic downturn.

• You can wait for decades if you invested at the wrong time in the wrong sector: we have had the dot-com bubble (similarity with FAANG?) and the real estate bubble.

The risk of investing in a limited amount of company's is that a big part of your portfolio will be wiped out if one of the company's goes bankrupt or crashes. You rather want to own 100 companies instead of one. If one of the 100 companies goes bankrupt, you will not feel it as much.

Ah, but I can diversify myself by buying more individual stocks

Yes, but three remarks:

• You need to buy a lot of shares yourself to properly diversify (1000+). See this link.

• Brokers costs will eat away your return.

• The reason why our neighbor made a killing was because he invested in 1 company which skyrocketed. Adding more stocks means he needs to pick all the winners and none of the losers to keep outperforming the stock market.

Which brings us to our conclusion

Yes, you can beat an index ETF. Yes, you can pick the winners. But doing so consistently and outperforming the stock market over a long term is very difficult. Most of the time, you are better of just investing in a global index ETF.