Jon Chevreau recently blogged (see John Bogle says investors getting killed by ETFs) on John Bogle’s analysis of returns experienced by investors in Exchange-Traded Funds (ETFs) and the results are not pretty: In 68 out of 79 ETFs, the returns experienced by investors lagged that of the ETFs themselves by an average of 4.5%. Bogle also found that investors in ETFs did much worse than investors in index mutual funds. In some categories such as large-cap stocks and small-cap stocks, the gap was particularly large — more than 7%. And the shortfall was as much as 12% in REITs! These results mirror that of the famed DALBAR study, which consistently finds mutual fund investors earning lower returns than the funds themselves (see Investors Behaving Badly).

I think the comparison of index mutual fund investors to those of ETFs is a bit simplistic. Unlike mutual funds, which are purchased by retail investors with the intention of holding for the long-term, the motivation for buying ETFs varies according to the type of investor. Some are passive investors who intend to hold ETFs in an indexed portfolio for the long-term. But most ETF buyers and sellers are traders who hope to profit from short-term movements. The popularity of ETFs with traders can be seen in the contrast in volume between Vanguard and iShares ETFs that track the same index. Despite charging less than half in fees, Vanguard ETFs such as the Emerging Markets ETF (VWO) and Europe Pacific ETF (VEA) have much lower trading volume than their corresponding iShares ETFs. Long-term investors would care more about the lower fees but traders would be primarily concerned with liquidity and low bid/ask spreads, not a MER difference of a few tenths of a basis point. Therefore, it shouldn’t be entirely surprising that, as a group, the returns from trading badly trail the overall market.

This article has 16 comments

  1. That makes sense to me. I have more holdings in ETFs (yep, for the lower fees), but they’re for the long-term, though. And I’ll still be edging my way out of mutual funds – I have about two or three that I will keep, that’s it. One of those is a bond index fund.

  2. Can someone explains to me how the MER applies when trading ETFs? I am new to this amazing world of trading and have recently bought and sold EWC and HOU which I was holding for short term. Other than paying the standard broker`s fees, I wasn’t charged MER or other fees.

  3. I’m not surprised that etf investors make the same mistakes as mutual fund investors – in a lot of cases they are the same people.

    I’m just guessing here but I think one of the biggest mistakes investors make is chasing hot funds/etfs. In that case it doesn’t matter what the investment product it – the end result is the same.

    Steve – ETFs charge a MER the same way as a mutual fund – every day a little bit is taken off the top. You don’t see it because the daily price is after the fees are removed.

  4. I think the morale of the story is that product is irrelevant if you can’t control your emotions regardless of whether you are retail or an institutional investor.

  5. Almost every study I have ever read has said that most people doing investing do worse than the index. That includes day traders or anyone else. That is the big reason why most of “us” promote index investing over any other sort. Once I have my portfolio up to a magic size I expect I will experiment with some trading, but that’ll be with my fun money and not anything important.

  6. Thanks FP.

    What I like about ETFs is that once you confirm the trend you can go long or short. Wouldn’t your returns be greater than riding the index fund long term?

  7. I’m curious about the discrepancy among index investors buying mutual funds vs. ETF’s. You’re reasoning (that there are now a variety of ETF’s and people may be ‘chasing’ sectors) is reasonable, but I wonder if it explains the entire difference.

    Too bad investors could not be separated into a strict buy and hold category, then the returns from index tracking mutual fund vs. ETF investors compared. Surely ETF investors should come out on top.

    Or does this suggest that DCA or some other behaviour is working to the advantage of the mutual fund investors?

  8. Sampson: My estimate of why ETF investers don’t fair as well as mutual fund investers is the difference of options. A mutual fund company has a very small number of choices, an ETF investor can easily invest in hundreds of individual stocks as well as ETFs. If you are in a mutual fund you are most likely to stay in one or more funds, if in the market you are likely to stay in the market.

    People in mutual funds tend to underperform the market. Some studies have shown that people make changes to their investments often enough to affect performance and most people are buy high, sell low people. It is not surprising that ETFs would have any different a showing, people move in and out as winds change and it is much easier to change ETFs than it is to change mutual funds (typically).

  9. @Steve: Yes. The study is not saying that ETFs underperform. It shows that people who use ETFs do not do as well as the ETF. AKA they buy high, sell low. If they bought and held then they would do exactly as well as the ETF.

  10. Canadian Capitalist

    @Steve: Many studies show that investors as a group are very poor timers. That doesn’t mean that *nobody* can time the markets but it does mean that as a group investors are very likely to remain poor timers. In theory, if you can jump in and out of stocks, you can boost your returns. In practice, very few manage to beat buy-and-hold.

    @Sampson: My sense is that the vast majority of ETFs (even the broad market index funds) are used for trading. Passive investors like us are probably in the minority. US investors have no reason to buy many of these ETFs — they can simply open an account with Vanguard and buy mutual funds for an extra 0.10% in expenses. If I were an US resident, I would go the mutual fund route given that my trading commissions are roughly on the order of 0.2% per year. Still, I’m only guessing but I do think ETFs can be valuable if used properly.

  11. “So we have evidence—strong evidence—that exchange-traded funds, because of the timing that goes on in them, are not acting in the best interest of investors. Or, that investors are not acting in their own best interests, which may be a better way to put it.”

    The last phrase may be a better way to put it, but it is still not exactly clear that Bogle is apparently really only refering to people trading these instruments as opposed to investing in them long-term. This point is made later in the article, though referencing mutual funds in particular.

    “these data are telling us something that is worth knowing … that mutual fund trading is about as valuable as trading individual stocks, which is to say, not valuable at all, and harmful to your returns.”

    I think that Bogle could have used less obfuscating language (pun intended) to get his point across, assuming that he is really only trying to point out that ETFs used as trading vehicles, (often) carry the same over-all dismal performance as any other instrument, if those instruments are used in an attempt to time the markets.

    At first, and even second blush this article reads like a good reason to avoid ETFs, when I think it should really be taken as a warning against trying to time the market, no matter your choice of weapon. Assuming this is his point, and though it may be a bit simplistic, I think that exchanging words like ‘trader’ and ‘trading’ for ‘investor’ and ‘investing’ would make this clearer. I say this based on a belief that most ppl think of the first as an active timing-(or even any other methodology) based trader, and the last as being a long(er) term buy and holder.

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  13. I agree it is difficult to compare mutual fund and ETF investors. Almost all mutual fund shares are held by retail investors The last time I looked at ETF statistics the majority of shares in the large index ETF funds (which represent by far the greatest portion of all ETF shares outstanding) were held by institutional, not retail, investors. Institutions like to describe themselves as long term investors, not short-term traders. If (!) one takes them at their word, then Bogle’s statistics mean there must be an awfull lot of retail ETF investors who trade in and out of ETFs. Such a use is not a great way to index invest, and I am not surprised such short term trading gives poor results.
    Marc Ryan

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  15. If my intention is to buy and hold ETFs long term, should I look at the trading volume when evaluating which ones to buy? Does a high trading volume have an effect on returns?

  16. ETf’s are generally passive investments that mirror a particular stock or bond index whereas mutual funds other then index mutual funds are actively traded trying to beat the market indexes.

    I would choose etf’s over index mutual funds as the fees are less for etf’s. The only time it may be beneficial to buy index mutual funds are if you are dollar cost averaging. If you are buying in every two weeks from your pay check index mutual funds make sense. You will be saving trading fees as every time you buy etf’s you with be charged a commission for the trade.

    Most equity active mutual funds do not beat the index so I am a fan of ETF’s or index mutual funds. I generally buy individual securities to try to beat the market but I also have a base of bond and equity etf’s. Hope this helps.

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