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Should ASX investors just buy ETF index funds for better returns?

‘Just buy the index’ is a common refrain you hear from investors these days. Index-tracking exchange-traded funds (ETFs) have become a popular pathway for investing in recent years. So much so that the most popular ETF in Australia – the Vanguard Australian Shares Index ETF (ASX: VAS) – now has over $4.8 billion in funds under management.

The ease, simplicity and passive nature of ETFs have driven this surge, together with the (quite frankly) dismal performance of ETFs’ actively managed counterparts.

So why bother trying to buy shares yourself when you can just ‘buy the market’?

Weighing up index ETFs

ETFs work by buying every share in an index – the good, the bad and the ugly. VAS, for example, holds the largest 300 companies in Australia, with the largest companies (like CSL Limited (ASX: CSL)) having far more weighting than the smallest.

The good news is that you can buy the market just through one single ASX share. ETFs typically have very low fees and expenses as well (VAS only charges a fee of 0.1% per annum for instance).

The bad news is that ETFs are designed to blindly follow an index – meaning the fund will be buying the strong shares along with the weak, the good companies along with the bad – with no discretion in between.

That means you are never going to outperform the ‘market’ because the ETF is the market. You are accepting an average return forevermore.

That might be just fine for those investors who don’t want to put any work into investing and have a very long-term horizon. History shows that even just investing in an ETF like VAS will give you far superior returns to just having your money in cash (even in a high-interest term deposit).

But if you want to use the stock market to generate market-beating returns, ETFs are not the best place to be.

Foolish takeaway

We Fools think anyone has the potential to beat the market (although it’s not easy). But it does require dedication, patience, and the right temperament.

For some people, active investing in this manner just isn’t the right fit, and so index-tracking ETFs might be the best option for those individuals. But if you want to learn how to beat the market, you will have to branch out beyond index ETFs and dive into the world of finding good quality businesses to buy into.

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Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.