How Much Better Are Exchange-Traded Funds Than Mutual Funds?

The conventional wisdom is that exchange-traded funds tend to outperform actively managed mutual funds over time. While this is true in the large-cap equity arena, mutual funds have been surprisingly competitive in certain areas.

In this respect, active managers are indeed adding modest value in asset classes where fundamental research or the ability to reduce exposure to certain underperforming market segments can provide an edge. However, it remains to be seen whether they can maintain this advantage over the long-term given their higher fees.

Below is a look at the relative performance of mutual funds versus the relevant ETF in each area.

Domestic Equities

The story on this front is an ugly one, and — since domestic stocks are the primary focus of so many investors — it’s probably the reason why mutual funds have developed a bad reputation. The numbers in the accompanying table tell the story: Funds have lagged their ETF counterpart by a wide margin in every area except small-cap value. That’s consistent with fund companies’ contention that small-cap value offers the widest latitude to add excess return through active management. On balance, however, these numbers serve as an indictment of the mutual fund industry — particularly in the “growth” segment:

3-Year 5-Year 10-Year
iShares Trust Russell 1000 Index Fund (IWB) 16.46% 0.02% 5.46%
Morningstar Large Blend Funds Avg. 14.19% -0.94% 4.68%
iShares Russell 1000 Growth Index Fund (IWF) 17.31% 2.71% 5.87%
Morningstar Growth Funds Avg. 14.83% 0.96% 5.19%
iShares Russell 1000 Value Index Fund (IWD) 15.55% -2.69% 4.89%
Morningstar Large Value Funds Avg. 13.82% -2.11% 4.68%
iShares Russell 2000 Growth Index Fund (IWO) 18.18% 1.94% 7.27%
Morningstar Small Growth Funds Avg. 17.34% 0.94% 6.70%
iShares Russell 2000 Value Index Fund (IWN) 17.28% -1.39% 6.22%
Morningstar Small Value Funds Avg. 17.37% 0.94% 6.70%

International Equities

In theory, active managers should have an advantage in the international arena in general, and in the emerging markets in particular. Information is somewhat to come by, and the markets are less efficient because of a lower intensity of analyst coverage. As a result, an on-the-ground presence by skilled research analysts should provide an advantage — at least in theory.

Mutual funds indeed have been more competitive in this area, albeit not by much. Actively managed emerging-market funds have held up well recently, but they have been trounced by the iShares MSCI Emerging Markets Index Fund (NYSE:EEM) in the longer-term time periods. The developed markets have been more of a bright spot for active management in the past three and five years, which likely represents funds’ ability to take below-benchmark weightings in the troubled financial sector (which makes up over 22% of the MSCI EAFE Index).

3-Year 5-Year 10-Year
iShares Trust MSCI EAFE Index Fund (EFA) 6.13% -6.37% 4.85%
Morningstar Foreign Large Blend Funds Avg. 6.38% -5.67% 4.73%
iShares MSCI Emerging Markets Index Fund (EEM) 8.64% -0.50% 14.08%*
Morningstar Diversified Emerging Markets Funds Avg. 8.96% -2.02% 12.77%
* Index performance substituted; ETF returns would be modestly lower due to fees

ETFs Hold a Smaller Advantage in Fixed Income

The bond arena is somewhat more difficult to judge because many of the largest ETFs are less than 10 years old. Still, from the three- and five-year results shown below, it’s evident that mutual funds, as a group, have added somewhat more value in bonds than they have in equities.

Over time, however, bond ETFs have a critical advantage: lower fees. In the fixed-income world, the issue of fees is much more pronounced given the low-yield environment. When Treasuries are yielding below 2%, an extra 25 basis points of fees makes a substantial difference. It is therefore reasonable to expect that ETFs will develop a solid advantage as time progresses and the impact of fees becomes larger. Already, this is visible in the areas where five-year results exist:

3-Year 5-Year
iShares Barclays Aggregate Bond Fund (AGG) 6.51% 6.59%
Morningstar Intermediate-Term Bond Funds Avg. 8.31% 6.20%
iShares Barclays TIPS Bond Fund (TIP) 9.35% 8.26%
Morningstar Inflation-Protected Bond Funds Avg. 8.91% 7.15%
iShares iBoxx $ High Yield Corporate Bond Fund (HYG) 13.56% 6.56%
Morningstar High Yield Bond Funds Avg. 14.39% 5.85%
iShares JPMorgan USD Emerging Markets Bond Fund (EMB) 12.41%
Morningstar Emerging Markets Bond Funds Avg. 12.54%
iShares S&P National AMT-Free Municipal Bond Fund (MUB) 6.80%
Morningstar Municipal National Intermediate Funds Avg. 6.65%

Gold Mutual Funds Outshine GDX

Mutual funds generally have lagged their respective ETFs (or indices, where ETFs didn’t exist) across the “alternative” investments space. Real estate investment trusts, commodities and leveraged loans have all been sources of underperformance for fund companies. However, funds have generated excellent relative performance in the gold space.

The challenge here, of course, is picking the funds that are above average. The dispersion of returns for gold-oriented funds is quite high, so investors could find themselves far below the category average if they pick the wrong fund. Still, the Morningstar category looks good versus the ETFs across all time frames:

3-Year 5-Year
Market Vectors ETF Trust Market Vectors Gold Miners 6.22% 4.13%
Morningstar Equity Precious Metals Funds Avg. 6.99% 4.31%

The Edge Goes to ETFs

Overall, ETFs have largely lived up to their reputation for outperformance. With the exception of small-cap value and gold, ETFs outpace mutual funds in the longest time periods where data is available.

There are two factors at work here. First, of course, ETFs’ lower fees provide them with an advantage right out of the blocks. While a half-percent difference might not seem like much in a single year, the impact of negative compounding becomes pronounced over longer-term time periods. Second is the general advantage of indexing over active management. Although indexing is by no means perfect — especially in the sense that it gives heavier weight to stocks with the strongest past performance — it’s no secret that it tends to finish far ahead of active management over time.

Ultimately, however, it’s not the reasons that count — it’s the results. And on that score, it’s clear that ETFs have a distinct advantage in domestic equities and modest outperformance in other areas. Still, mutual funds can continue to add value in certain market segments — investors just need to know where to look.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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