Is ETF Tradability Good or Bad?

(MoneyWatch)  Exchange-traded funds (ETFs) are a great innovation, bringing low-cost and tax-efficient investment vehicles to retail investors. One of the touted benefits of ETFs is that you can trade them easily and throughout the day, which you can't do with open-ended mutual funds. But is this attribute good or bad?

When I discuss active versus passive investment strategies, I like to point out that active investors have the disadvantage of being able to time the market or select stocks they think are mispriced. There's an overwhelming body of evidence on the failure of active management to achieve positive risk-adjusted returns on a persistent basis.

The August 2009 issue of Exchange-Traded Funds Report provided further evidence on how active strategies can destroy investor returns. The issue discussed a study by John Bogle, the founder of the Vanguard Group. Using data from Morningstar, Bogle showed the annualized, five-year time-weighted returns earned by ETFs and compared them to the dollar-weighted returns earned by investors in those same ETFs. The former are investment returns and the latter are investor returns. As you'll see, there can be quite a difference.

	Fund Return (%)	Investor Return (%)	Investor Lag (%)
Large-cap blend	-1.4	-5.7	-4.3
Large-cap growth	-1.7	-7.7	-6.0
Large-cap value	-1.8	-2.2	-0.4
Mid-cap blend	0.4	-3.0	-3.4
Small-cap blend	-0.5	-6.9	-6.4
European/Pacific	3.1	0.5	-2.6
Emerging Markets	15.6	3.8	-11.8

The evidence demonstrates that investors are better off when snoring than when awake. In each asset class, their actions were counterproductive, reducing returns available by from 0.4 percent per year to as much as 11.8 percent per year.

Bogle also showed that the results from sector ETFs were even worse. In the seven sectors studied, he found that investor actions reduced returns anywhere from almost 2 percent per year (health care) to as much as almost 18 percent per year (financials).

The evidence is clear that if you invest in ETFs, you're best served by following the example of Odysseus. Knowing he would be tempted by the Sirens call on his voyage, which would lead to danger, he tied himself to the mast of his ship to avoid giving in to their song. Similarly, you should do what you must to avoid giving in to the temptation to actively trade ETFs. Rebalancing and tax-loss harvesting are the only "active" strategies prudent investors employ.