Are Investors Being Burned by the ETF Gold Rush?

Exchange-traded funds (ETFs) are a bright light in an otherwise quite dim mutual fund industry. While many mutual fund managers have seen investor money leak out of their stock and bond funds, ETF managers continue to attract billions of dollars from investors. While that's good news for ETF managers, the evidence suggests that this trend hasn't been an unalloyed benefit for investors.

The growth of ETFs has been nothing short of remarkable. In just over 15 years, they've grown at such a staggering pace that their total assets now surpass the assets of traditional index mutual funds. Even more impressive, in the wake of the bear market, that growth is accelerating. Since 2007, the four largest ETF managers (Barclays, State Street, Vanguard, and ProShares) have seen nearly $250 billion of new money flow into their stock and bond funds. The rest of the mutual fund industry combined, meanwhile, has seen nearly $200 billion of net cash outflow.

But this broad investor acceptance masks a point that Vanguard's Jack Bogle made very nicely in a presentation he gave last month for an audience at IndexUniverse.com: The returns earned by the average ETF investor have lagged the returns earned by the ETFs themselves, in most cases by substantial margins.

In and of itself, that fact doesn't make ETFs terribly unique -- the returns of investors in most mutual funds have lagged the returns the funds have earned. But the ETF performance is quite stark when we compare their investors' returns to those earned by investors in traditional index funds. To illustrate this contrast, let's take a look at five year performance of the funds that fall into the nine Morningstar style boxes (large-cap blend funds, small-cap growth, etc.). (We'll have to limit our comparison to seven of the nine boxes, because two of the mid-cap categories do not yet have any traditional index funds with five year returns.)

Taken as a group, unsurprisingly, the annual returns of the ETFs and traditional funds in these groups are fairly close -- an average return of -1.5 percent for traditional funds versus -1.4 percent for ETFs. But the investor experience in the two types of funds is worlds apart. The average investor in traditional index funds earned -1.8 percent per year -- barely trailing the actual funds' return; the average ETF investor's return was -5.4 percent, fully four percentage points worse than the average ETF. Compounding those figures over five years produces a cumulative loss of 24 percent for ETF investors versus a nine percent loss for fund investors.

The chart to the right breaks these figures out by style box. As you can see, in four of the seven boxes, traditional fund investors earned returns that surpassed that of the funds they invested in; ETF investors, on the other hand, lagged in every category by up to 6 percentage points per year.
What explains this discrepancy between investments that are, for all intents and purposes, essentially equivalent? One word: Trading.

If you can remember back to the days before the ETF industry was dominated by the often-bizarre index mashups (a carbon emissions fund, anyone? ) so prevalent today, the only real differentiating characteristic on which they were marketed was their liquidity -- you could buy and sell them throughout the day, whereas traditional mutual funds are priced at the close of the market.

It's little surprising, then, that ETFs appealed most to investors for whom this was liquidity was important, i.e. investors who were interested in trying to time the market. And in the wake of 2003's mutual fund timing scandal, traditional index funds largely told market timers to take their business elsewhere, further pushing market timers into ETFs. That genesis, combined with the staggering array of market niches that ETFs cover means that, for better or worse, they're largely used by investors who wish to bet on which way the market is going in the short-term rather than investors looking to buy and hold.

Of course, the evidence very clearly demonstrates that ETF investors are doing a pretty lousy job of market timing. But judging from their continued growth -- in terms of both assets and funds -- investors have yet to learn this lesson.

Does this mean that investors should favor traditional index funds over ETFs? Absolutely not. They can be great products that offer investors an inexpensive way to gain exposure to the stock market. They can also be slightly more tax efficient than traditional mutual funds.

But the ETF industry strikes me as one that's in the tail end of a gold rush, as providers are falling all over themselves to innovate and seize market share. I've spoken with a number of people who work at these firms, and they inevitably defend their latest spurious concoction along the lines of "Well, it's attracting assets. Investors clearly want it."

And that's certainly true. But history demonstrates that what investors are currently clamoring for is precisely the thing that's worst for them. It would be nice if some of the ETF providers were able to step back, take the long view, and come to the conclusion that just because there's a demand for a fund that provides double the return of the Peruvian market (not that there is, yet), meeting that demand will ultimately dent their reputation in the long run.

In the end, mutual fund managers essentially decide to build their business on one of two types of investors: serious investors who are interested in building their wealth over the long term; and those seeking to strike it rich by hopping from one investment fad to another. Investors in the former category can certainly use ETFs to help reach their goals. It's just a shame that the ETF industry, by and large, seems to be spending so much time trying to appeal to the latter group of investors instead. Don't be one of them.