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.
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
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?
Hulbert speculates that some of ETFs' advantages can
all-too-easily turn into disadvantages. ETFs can be traded all day
long, rather than just once a day like open-end funds. They can
also be sold short--that is, you can bet that they'll fall in
price. Those qualities, Hulbert suggests, have tempted advisers to
trade too often and to short ETFs. Neither strategy has been
helpful during the bull market, which celebrates its fifth birthday
on March 9.
I think Hulbert has part of the answer. The bigger part, I
believe, has to do with the incredible variety of ETFs. Yes, there
are far more open-end funds than ETFs. But most open-end fund
managers toil at beating one of the broad market averages, such as
Standard & Poor's 500-stock index, which focuses on large U.S.
companies, or the Russell 2000 index of small companies. Most
managers fail, but they don't typically get killed; over long
periods, most of them finish a small amount behind their benchmark
on an annualized basis.
ETFs, on the other hand, boast a mind-numbing list of narrow and
esoteric strategies. You think the Russia-Ukraine crisis will be
resolved quickly? SPDR S&P Russia ETF (symbol
) has your number. You may not be able to find Indonesia on a map,
but you can invest in small Indonesian firms via Market Vectors
Indonesia Small-Cap ETF (
). Back in the '60s, I used to listen to the music of a rock band
called Rare Earth. Today, I can invest in Market Vectors Rare
Earth/Strategic Metals (
), which tracks an index of stocks involved in producing, refining
and recycling these metals and minerals.
ProShares offers a variety of ETFs that let you short indexes or
even get double or triple the daily return of an index. "Geared
(Short or Ultra) ProShares ETFs seek returns that are either 3x,
2x, -1x, -2x or -3x the return of an index or other benchmark,"
says ProShares' Web site.
Think of funds as an investing toolbox. The toolbox containing
open-end funds is filled mainly with tools you know how to use:
hammers, wrenches and screwdrivers. Usually, the worst you'll do
with these tools is hurt a finger. The ETF toolbox, meanwhile,
contains a whole lot of tools that can blow up your house. And, by
the way, a lot of these strange and dangerous ETFs cost almost as
much as open-end funds.
None of this is to defend open-end funds. Almost all of them do
charge too much and, consequently, lag their benchmarks. Indeed,
the open-end fund portfolios that Hulbert tracked fail to match the
S&P 500 over any period except the ten-year stretch through
ETFs have a lot to commend them. But stick with broad-based,
low-cost ETFs from companies such as Vanguard, as I recommend in my
column on the
Best ETFs for 2014
. Don't be seduced into using ETFs to slice the markets into tiny
pieces--or into trading them. As Hulbert shows, ETFs can be
hazardous even in the hands of professionals.
is an investment adviser in the Washington, D.C., area.