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By Christine Benz | 10-18-2012 02:00 PM

Is Tradability a Liability for ETF Investors?

Differences in stated returns and investor returns in ETFs are more dependent on time periods and other factors versus destructive investor behaviors spurred by the intraday tradability of ETFs, says Vanguard's Fran Kinniry.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

The ability to trade exchange-traded funds throughout the day has led some market watchers to conjecture that ETFs could lead to bad investor outcomes.

Joining me to share some recent research on this topic is Fran Kinniry. He is a principal with Vanguard's Investment Strategy Group.

Fran, thank you for being here.

Fran Kinniry: Thank you, Christine.

Benz: You recently looked at the dollar-weighted returns in exchange-traded funds versus traditional mutual funds, and you compared the results.

First, let's talk about what dollar-weighted returns are, and how they're different from the familiar total returns that investor see when they look at their funds.

Kinniry: Sure. Just to level-set everyone, funds, if you go look on the web or you look on Morningstar, you get published time-weighted returns, which is known as TWR, the abbreviation. That's just the return of the fund or the investment itself. It does not take into account any cash flow in or out.

Benz: So that's just this basket of securities, what it returned?

Kinniry: Basket of securities, what it returned. And the easiest example, if I put a dollar in on Jan. 1, no [other] cash flows in or out [during the year], my time-weighted return would then equal my dollar-weighted return, because I had no cash coming or going.

The second form, of which Morningstar has done a great job and other providers are starting to look at is, well, how did the investor do? And the investor returns are known as IRR or internal rate of return. What that capture is, well, how did the actual dollars go in? In my prior example, I said if I put a dollar in on Jan. 1, and held it, those two would be equal. Now, suppose that I put a dollar in on Jan. 1, but then I put another dollar in on June 1. And if my returns in the first half of the year were different from my second half of the year, I would have a different result in my dollar-weighted return IRR to TWR.

Benz: … So you looked at flows into ETFs and traditional mutual funds. I think one of the assertions about ETFs is that they would encourage this wild trading, that investors might be inclined to buy the hot ETF and sell it at an inopportune time.

What did you find when you examined the dollar-weighted returns versus the time-weighted returns for ETFs and traditional mutual funds?

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