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You Say You Want a Revolution?

To be truly revolutionary, ETFs must maintain their best practices and force the established industry to reform theirs.

Don Phillips, 08/04/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

Exchange-traded funds offer a chance to reform the investment industry and tilt the odds more in investors' favor. They have been heralded as game-changers. Indeed, their reputational advantages are as significant as their structural ones. Most advisors who are embracing ETFs aren't doing so out of an overarching belief in passive investing or a desire to trade client accounts during the day. They are moving toward ETFs because of the trust and goodwill that ETFs have earned. But the question of whether ETFs will squander their moment remains a real one. To be truly revolutionary, ETFs must maintain their best practices and force the established industry to reform theirs. Some of this is happening, but the results to date suggest that ETFs are deteriorating far more than traditional funds are improving.

I think of ETF development in three waves. First, there were the pioneers. These were broadmarket index funds that offered material advantages over the mutual funds of the day. At an average of 17 basis points, their expenses were one sixth those of the typical fund. Their average turnover ratios of 10% were one eighth that of the average fund, implying far greater tax efficiency. Being fully invested equity index funds, they subjected investors to more volatility than did traditional funds, which were more diverse. Still, their collective superiority in cost, tax efficiency, and transparency did much to craft the public's positive view of these new vehicles-a view that subsequent ETFs continue to exploit, if not honor.

Next came the expansion phase. From 1996 to 2005, more than 150 ETFs were launched. These new funds maintained advantages over existing funds, especially as the new mutual funds of that era were even more costly and less tax-efficient than their predecessors. The ETFs of the second wave were on average one fourth as expensive as traditional funds. Their turnover ratios were one fifth as high. From a cost and tax standpoint, these ETFs still had compelling advantages. Somewhat troubling, however, was the trend. Their costs and turnover rates were double those of the pioneering ETFs. More disturbingly, their volatility marched higher. As we've shown with our work on investor returns, higher-volatility offerings tend to lead to greater behavior gaps-that is, investors are more tempted to buy high and sell low. Still, while there were cracks around the edges, ETFs still offered revolutionary advantages over traditional funds.

Then came the ETF explosion. Since 2005, more than 1,000 ETFs have launched. More choice is surely good, but sadly the quality of the choices continues to slip. The costs associated with this third wave of ETFs again nearly doubled from the previous group. Unsettlingly, that's the current net expense ratio, which reflects voluntary, but not guaranteed, fee waivers. The gross expense ratio is 0.95%, something that looks much more like that of a traditional fund, not that of a revolutionarily low-cost vehicle. The turnover story is also troubling. At 37%, it's still better than that of regular funds, but many studies have shown that once turnover goes beyond 20%, claims of tax efficiency are lost. That, coupled with the tax nightmare of many commodity exchange-traded products, which are taxed as collectibles, means that the promise of tax simplification through ETFs has become tarnished, if not lost. The risk story is even worse. This third wave of ETFs, despite having more fixed-income offerings, offers volatility at rates now 50% higher than those of traditional funds, likely resulting in huge gaps between stated returns and actual investor gains. If ETFs are to revolutionize investing, they must produce a superior investor experience. Higher volatility, even when packaged transparently, is unlikely to produce a better experience, especially with less-sophisticated investors.

The exploitation of early achievements is the inevitable consequence of revolution. The boldness of the pioneer is diluted by weaker imitators and is ultimately co-opted by the very establishment the pioneers challenged. Think how The Beatles led to The Dave Clark Five and Herman's Hermits, which in turn begat corporate creations like The Monkees and The Archies. The steady descent toward mediocrity of ETFs hasn't been pretty and will get worse. Still, investors have many great ETFs from which to choose, and we are seeing traditional funds finally lower their fees and marginally improve their practices in response to ETFs. In that sense, the ETF revolution will likely lead to lasting benefits for all investors. 

Don Phillips is Morningstar's president of fund research.

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Don Phillips is a managing director of Morningstar, Inc.

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