The Dark Side of Exchange-Traded Funds
Many investors think that low-cost exchange-traded funds are better choices than ordinary, old-fashioned, open-end mutual funds. And they have a point. With most broad-based index ETFs, you know the fund will match its benchmark, minus piddling expenses. However, open-end funds generally lag their benchmarks because they charge outrageously high fees. Only suckers buy them.
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Or maybe not. A fascinating study by Mark Hulbert, editor of the Hulbert Financial Digest, which tracks the performance of investment newsletters, finds that ETF investors may be the bigger losers.
Hulbert tracked the model portfolios of newsletters that offer both ETF portfolios and portfolios that invest solely in open-end funds. In 2013, the portfolios consisting of open-end funds returned 20.9%, on average. That was 3.0 percentage points ahead of the average ETF portfolio.
ETF portfolios likewise lagged over longer periods. For the five years that ended last December 31, the average open-end fund portfolio returned an annualized 14.2%, beating the average ETF package by an average of 2.6 percentage points per year. Over the past ten years, the open-fund portfolios returned an annualized 6.9%, an average of 2.0 percentage points per year better than the ETF portfolios.
It’s an elegant little study. By looking at the returns only of advisers who offer both ETF and open-end fund portfolios, Hulbert provides a meaningful test of how advisers do at picking ETFs compared with how they do picking open-end funds.
What’s going on here? ETFs usually charge much lower prices than open-end funds. Why don’t ETF portfolios do better?