Management fees seem to be an important criterion for fund selection; investors often state that exchange-traded funds (ETFs) are too expensive from their point of view, since some traditional index funds charge lower fees for tracking the same index. Fees and expenses are important, but shouldn’t an investor look as carefully at the returns delivered by the products? To me it makes a lot of sense, especially for passive products, to look more at the returns than the expenses.
A comparison of index products registered for sale in France, Germany, Switzerland, and the United Kingdom in the Lipper Global Classification sectors Equity Europe, Equity Eurozone, Equity France, Equity Germany, Equity UK, and Equity US showed there are index trackers available that have lower management fees than their respective ETFs. But how did they compare performance-wise over short-, mid-, and long-term horizons? We looked at the performance over one-year (October 1, 2014–September 30, 2015), three-year (October 1, 2012–September 30, 2015), and five-year (October 1, 2010–September 30, 2015) periods to see if there were any significant differences in the returns. To compare apples with apples the funds were grouped based on the index they track.
This comparison showed that ETFs tracking the French CAC 40 TR, the German DAX 30 TR, the U.S. S&P 500, and the European regional indices Euro Stoxx 50 NR and MSCI Europe NR outperformed their traditional peers over the one-, three-, and five-year periods.
Funds tracking the French CAC 40 NR showed a mixed picture; an index tracker showed the best performance over one year, while ETFs led the table over the three- and five-year periods.
The same pattern was shown by funds tracking the U.S. S&P 500 TR index. In contrast, two traditional index funds (UBS (CH) Inst Fund 2-Equity USA Passive I-B and ZIF Aktien USA Passiv A1) led the table for funds tracking the MSCI USA NR over the one-, three-, and five-year periods. It was remarkable that these funds didn’t show any suspicious performance patterns, i.e., the funds produced a consistent outperformance over their peers.
Equities UK seemed to be an exception from the dominance of ETFs, since traditional index funds tracking the FTSE 100 TR or the FTSE All Share TR index showed the best performance overall for the analyzed time horizons. Even though this might be seen as evidence that index trackers are the superior products for investment in U.K. equities, one needs to bear in mind that the leaders in the respective categories changed over time, and the best funds over three years profited in the ranking from the performance pattern shown for the one-year period.
Since all the funds probably apply modern portfolio management techniques, there must be another reason that traditional index funds underperform ETFs in the most analyzed market segments in this study.
From my point of view transaction costs are the major reason for the underperformance, since these costs are treated totally differently by these two fund types. While traditional funds have to buy and sell stocks on the market when investors buy or sell shares of the fund, ETFs don’t face any of these transactions. All transactions for the creation and redemption of shares are done by a so-called authorized participant. While the traditional index fund has to pay the transaction costs out of the assets of the fund, impacting the performance, the transactions for the ETF shares are paid by the investors via the bid/offer spread and do not impact the fund’s performance.
Conclusion
Even though traditional index funds do not underperform ETFs in all markets, ETFs seems to be the better solution with regard to their performance, especially for mid- and long-term investors. That said, it is remarkable that some ETFs are positioned at the bottom of their respective tables, leading to the conclusion that investors have to do proper due diligence before buying an ETF.
In addition, one needs to bear in mind that the study looked just at performance, and no assumptions were made with regard to the quality of the index replication, i.e., ratios such as correlation, tracking error, and tracking difference were not taken into account for any of the evaluations.
This study showed that expenses should not be used as the only criterion for selecting funds, since that might lead to products that are cheap for management fees but very expensive for the underperformance they might generate in the investor’s portfolio.
The views expressed are the views of the author, not necessarily those of Refinitiv.
