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ETF Specialist

How ETFs Fit Into the New Investment Landscape

Why fees are more important than ever.

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The case for low-cost investing is stronger in a world of low expected returns and increasing sophistication, and index funds and exchange-traded funds are a great way to keep expenses to a minimum.

The financial crisis and its echoes have led many investors to revise their investment strategies. The two major thrusts among institutional investors have been either to search harder for funds that may outperform or to hold more low-cost index funds. Most investors and advisors will be better off adopting the low-cost approach as the quest for a shrinking market-beating pie becomes more brutal and the penalty for mistakes becomes even steeper. ETFs and other passive vehicles are great ways for investors to earn a fair share of the slower-growing market pie.

Everything's Expensive
In order to boost low consumer demand, central banks have driven down real interest rates to punishingly low levels. The theory is that cheaper capital will encourage businesses to invest and banks to make loans, and inflated asset valuations will make consumers feel richer and more open with their wallets. The banks have succeeded in that risk-asset prices have risen and expected returns have fallen.

Low expected returns effectively increase asset-based fees such as expense ratios. Another way to think about fees is as a percentage of an asset's or a strategy's expected return. Through this lens, a 1% annual charge is egregious for an asset expected to return 2% annually--half the expected returns are consumed--but reasonable for an investment expected to return 10%. However, asset-based fees are sticky, so throughout a market cycle, a strategy's costs as a portion of expected returns can vary dramatically. When markets are overheated and therefore likely to underperform going forward, investors paradoxically are willing to pay higher fees and to believe that fees as a portion of future returns are de minimis. The mechanism works in reverse when valuations are depressed.

Many investors are unaware that an asset class's long-term expected returns can be reasonably estimated by summing the asset's carry (or yield) and the carry's expected growth. (We are ignoring changing valuations, as they wash out over time and are driven by sentiment.) Over long periods, dividend growth per share has been stable for most economies at about 1% a year in real terms, allowing for surprisingly predictive long-run return estimates for equities. Similarly, yield-to-maturity and historical default rates do a decent job for bonds. For almost all asset classes, current yields suggest a low-return world going forward, perhaps one of the reasons why managers like PIMCO's Bill Gross and GMO's Jeremy Grantham are gloomy about long-run risk-asset returns.

As of writing, the Barclays Capital U.S. Aggregate Bond Index's yield to maturity is 2.5%, implying a subnegative 1% forward-looking real return. With such slender returns, fees become even more important.  Vanguard Total Bond Market ETF (BND) 0.11% will consume only about a 10th of the expected real return, but  iShares Barclays Aggregate Bond's (AGG) 0.24% expense ratio will take up nearly a fourth. The same logic applies to the U.S. stock market, which has an expected return equal to its dividend yield plus dividend growth (1.7% + 0.2%) or about 0.4% real. Investors should strongly consider whether it's wise to pay 1%-plus expense ratios, or effectively 25% of their expected real returns, for U.S. equity strategies. A cost regime calibrated for a high-return world will leave investors shortchanged.

A Look Back at Large-Blend Equities
A number of ETFs have accumulated 10-year performance track records, a long enough time frame to lend some statistical confidence on the debate on index mutual funds versus ETFs. Still, there are challenges to conducting long-term studies of funds that necessitate the use of some assumptions. For example, there is a survivorship bias if we only take into account funds that survive the entire period because the weaker funds tend to disappear. But investors care about risk and returns, not an arbitrary success ratio. Was the upside in the 22% of the funds that beat the S&P 500 worth the risk of ending up in one of the 78% of the funds that did not?

To answer this question, we need some way to deal with the large number of funds that did not survive the study period. One way to deal with survivorship bias is to substitute a return for the funds in the months after they disappear. We could assume that investors in closing funds reinvest in the index or receive a return equal to the average of all of the remaining funds. Using the index return is perhaps the most generous to the disappearing funds because it does not include any expense ratio drag and it ensures the fund will at least match the benchmark after it disappears.

Over the last 10  years, the S&P 500 returned 2.82% on an annualized basis.  SPDR S&P 500 (SPY) returned 2.75%, while  iShares S&P 500 Index ETF (IVV) returned 2.76%. The median active mutual fund returned 2.3%, while the median index fund returned 2.53%. SPY and IVV outperformed 68% of the 758 actively managed large-blend mutual funds and 82% of the 249 index funds. So, clearly you were better off with either ETF than you were in a random large-blend mutual fund. In terms of the spread of performance, the top 5% of active funds outperformed by 1.7% per year, but nearly 5% of the active funds at the bottom lost money. Risk-averse investors are typically willing to accept lower returns with certainty than a higher return with the possibility of underperformance. So the fact that active mutual fund investors are getting lower returns and more uncertainty is puzzling.

Harder, Better, Faster, Stronger
Of course, none of this matters if investors just pick the best managers. But it's very difficult to do, and getting harder over time. According to an influential study by Robert Kosowski, Allan Timmermann, Russ Wermers, and Hal White, from 1975-2002, the top 10% of funds exhibited significant skill; but after 1990, the number of truly skilled funds became much rarer. In a more recent study published in The Journal of Finance, Laurent Barras, Olivier Scaillet, and Russ Wermers found that while skilled funds were relatively prevalent prior to 1996, by 2006 they became extremely rare. Increasing market efficiency is what you'd expect from an economy that has increasingly diverted its smartest individuals to asset management.

Actively managed fund champions obviously counter that no one selects funds at random. Indeed, we agree that your willingness to select a fund in the same category but with higher expenses should be paired with a rigorous analysis of several factors that can help predict future success. Remember, there are plenty of low-cost options in the actively managed space as well. Other research shows that investors are actually pretty good at identifying funds with a better chance of outperformance than simple studies on all funds would indicate. An alternative way to adjust for survivorship basis is to use asset-weighted returns. This has the added benefit of reducing the impact of small funds that no one cares about and focuses on where people have actually put their money. By this method, the 2.69% return of all large-blend mutual funds is right on par with the ETFs.

Also, there are plenty of bad index funds as well. The worst 25% of index funds in the large- blend space 10 years ago underperformed the S&P 500 by 0.55% or more over the next 10 years. Just because a fund follows an index, does not make it optimal. Some products--witness the smartphones of  First Trust Nasdaq CEA Smartphone Index (FONE)--are designed to extract rents from unsophisticated consumers, while others are more subtle, such as closet-index funds posing as active managers or funds selling repackaged style tilts as a new and better way of picking stocks. Even the smart money players have been among the biggest losers in deals, thanks to one-sided information. In one infamous example, Goldman Sachs repackaged and sold lousy mortgages to other institutions, mere weeks before the products went horribly wrong.

Morningstar ETF Analyst Michael Rawson, CFA, contributed to this article.




Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.