Exchange-traded funds (ETFs) have significantly grown in popularity over the last two decades. I think there's a very important reason why ETFs are so good.
There are many different ETFs to choose from, such as the Vanguard Australian Shares Index ETF (ASX: VAS) which is invested in the S&P/ASX 300 Index (ASX: XKO), being 300 of the largest businesses on the ASX.
Investors can also choose ones like the iShares S&P 500 ETF (ASX: IVV), Betashares Nasdaq 100 ETF (ASX: NDQ) or the Vanguard MSCI Index International Shares ETF (ASX: VGS) which help investors gain exposure to the global share market.
There are several reasons to like the ETFs that I've already mentioned including the diversification of the portfolios and the low management fees. But, there's a particular reason why I think they're effective.
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Portfolio evolution
When we look at the returns of the ASX share market or the US share market, the ultra-long-term returns have been impressive – the average return per annum over the decades has been around 10%. That's a good rate for wealth compounding.
ETFs have a very useful model where they let go of the businesses that are suffering and getting smaller, while investing more in the ones that are growing and thriving. It's not a perfect system, but it means that they don't hold onto duds forever until they go bust.
But, If we individually bought shares of the 50 biggest businesses in the US or Australia today and held them for thirty years, I don't think the overall returns would be very good because many of them could decline over time.
Think about names like Blackberry, Kodak and Yahoo that have significantly fallen from their peak powers. The ETF's portfolio (and overall share market) is regularly updated to own the current crop of winning businesses.
While index-tracking ETFs may not shoot the lights out, they do enable investors to move on from any disappointing businesses.
In 20 or 30 years, I expect the Vanguard MSCI Index International Shares ETF will still be invested in many leading global businesses, even if the portfolio's names are very different compared to the current crop of companies.
Foolish takeaway
I believe that passive investing is a very effective way to ride the share market's returns. Having diversification and low fees is a major selling point, but I do believe that it's an ETF's ability to regularly shift its portfolio that can help it continue to perform over the long term.
