ETFs are a form of indexing. Indexing is investing in funds that hold the same basket of stocks and/or bonds of a particular market index. These funds are passive, meaning they don’t buy and sell the individual pieces, expect for buying additional shares with new money. The basket only changes when the index changes, and this usually happens in small percentages each year. An example of indexing is when an investor purchases the S&P 500 index. The S&P 500 represents some of the 500 largest companies in the US. If you buy one share of the S&P 500 index you will be purchasing all 500 companies.
Actively managed funds, however, have a fund manager that buys and sells the individual stocks and bonds on a frequent basis in an attempt to beat a market index, not just follow it. The frequency of turnover can be high – turnover being the replacement of all the stocks and bonds in the portfolio with new ones. The performance of such funds is said to be superior based on the skill of the fund manager, but studies have shown that active fund managers are more a victim of luck than actual skill. The University of Maryland has a study that shows only .06% of active fund managers from 1975 – 2007 beat their corresponding index.
The benefit to you is lower fees. Fund fees include the transaction fees of trading, and the salary and bonuses paid to the fund manager. Fees for ETFs are in the 0.07-0.50% range generally, while actively managed mutual fund fees can be in the neighborhood of 1-3% or more, because of more frequent trading and the highly paid fund manager. Fees are taken off the top of earnings. For example, if a fund earns 10% but has fees of 3%, you only see a 7% return on your investment. An ETF that earns the same 10%, but with fees of 0.50%, leaves you with a 9.5% return.