Articles

Is That An Elephant In The Room?
By Jim Wiandt

Page 1 of 5

Index fund managers don't talk about relative performance very much. After all, they are index funds. Generally speaking, they track the market … or at least, they should. When's the last time you heard someone boast at a cocktail party about the relative performance of their index fund?

"I've got this little mid-cap fund that beat its benchmark by seven basis points this year."

That would really bring a hush to the room…

As more sophisticated investors know, however, the truth is that there is a substantial difference between different index funds. Five or ten basis points may not sound like much, but multiplied by billions of dollars over dozens of years, those basis points really add up. Index fund managers know this - one told me that he would sell his mother for three basis points - and the issue of mutual fund performance is one that deserves a great deal more attention than it receives today.

That's particularly true for one of the most controversial topics in the index investing arena theses days: exchange-traded funds, or ETFs. As ETFs grab a larger and larger share of index-based assets, no one seems to be talking about how they perform relative to traditional index mutual funds. It's the elephant in the room. People talk about the operational differences - ETFs trade like stock, have certain tax advantages, etc. - but the central question remains largely unanswered: Is an investor better off in a traditional mutual fund or an ETF?

This story has simmered below the surface of the ETF industry for a number of years, but we're going to bring it to a boil today. This article aims to take an authoritative look at the current data and provide a survey of the various factors impacting the performance differences between ETFs and traditional index mutual funds.

Updating Bill Bernstein

It's not quite true to say no one is talking about these issues. Bill Bernstein, one of the leading lights of asset allocation research, has covered the topic on two occasions. In a 2001 article on his excellent Web site, www.efficientfrontier.com, Bernstein compared the performance of ETFs and traditional index-based mutual funds.¹ His conclusion? ETF performance was pretty good. The article helped set the fledgling ETF industry on a solid footing, providing a strong independent endorsement of what was at the time a radical new product.

In the spring of 2004, however, with the ETF industry established and more long-term data available, Bernstein largely recanted. In a detailed and scathing article, Bernstein concluded: "How do I really feel about ETFs? I don't buy them. Not for myself, my family and, in particular, not for the clients of our advisory firm. The reason? Because, in most cases, you can do better."²

Ouch.

In March of 2006, newsletter guru Mark Hulbert piled on with a comparative analysis of ETF newsletters, concluding that, somehow, the body of ETF newsletter portfolios managed to get run over by any reasonable gauge of the market.³

Figure 1 shows the numbers that Bill Bernstein came up with in 2004.

Mr. Bernstein had the good sense to keep his study very simple; he basically compared Vanguard mutual funds vs. iShares ETFs from Barclays Global Investors (BGI), with the exception of using the SPDR for his U.S. large-cap ETF. He also had the good fortune of working with a data set that was easy to compare; Vanguard switched many of its domestic index funds to the new MSCI US indexes in 2004, making head-to-head comparison more difficult to achieve today.

From an investor standpoint, I remember thinking that it was hard to argue with the logic of Bernstein's straightforward comparison, as Vanguard/iShares put you in at least the vicinity of "best of breed," which is the category I try to buy my funds from. Bernstein really provided no analysis of the "why," however, and in the last two years, with Vanguard radically expanding its ETF offerings and a flood of new BGI and SSgA (as well as many other) ETFs entering the market, I figured it was time to take as definitive a look as possible at a big issue-and the issues really don't get much more important than investor returns.

With more data history and more ETFs available, we've taken a much broader look at the data than Bernstein did, using many more points of performance comparison. In addition, we've focused on absolute return differentials. While it's certainly interesting to take out the expense ratios and look at tracking error, the bottom line is what I'm most concerned about, and expense ratios (ERs) are the most unchanging and predictable part of the bottom line (barring the occasional increase or decrease in ER). While it is valuable to see where the different funds are in terms of their tracking skill, bear in mind that this could change.

Before we get to all that, let's take a category-by-category look at what causes returns differentials among various funds and between traditional mutual funds and ETFs.