Passive Mutual Funds and ETFs: Performance and Comparison

Edwin J. Elton and Martin J. Gruber are Professors Emeritus and Scholars in Residence at NYU Stern School of Business, and Andre de Souza is Assistant Professor of Finance and Economics at St. John’s University Peter J. Tobin College of Business. This post is based on their recent paper.

Over 25% of the assets held by investment companies are held in the form of passive index funds and passive exchange traded funds. Furthermore, many indexes are followed by multiple passive funds. Empirical evidence shows that active funds underperform indexes by about 75 basis points. Given these facts, it is important for investors to understand how to make the choice among and between index funds and ETFs for any particular index. The purpose of this paper is to explain what affects performance and how to choose between passive vehicles.

In the first part of the paper, we examine return pre-expenses which measures management’s performance. Managers closely follow their index resulting in an average R2 above .996 and an average beta of 1 for ETFs and .998 for index funds. On average, ETFs pre-expenses slightly outperform the index they follow, while index funds slightly underperform.

In the next section of the paper we examine the factors that account for differences in the performance of index funds and ETFs relative to the indexes they follow. Cross-sectionally, the major factors affecting pre-expense performance for index funds are turnover and the number of passive funds in the same family. For ETFs, the major determinants of the differential return across funds following the same index are the number of passive funds in the same family and the amount of security lending they do. When we examine what determines cross-sectional return post expenses, the same factors matter. However, the expense ratio becomes much more important in affecting differential return.

We next examine how to pick the best ETF and the best index fund separately. We have two criteria: expense ratio and expense ratio plus the factors affecting pre-expense return. Picking the lowest expense index fund rather than the average index fund improves return by 33 basis points for institutional investors or 38 basis points per year for retail investors. For ETFs, the difference is 5 basis points per year since there are fewer choices. For index funds, 83% to 86% of the funds have lower returns in the next year compared to the lowest expense fund and for 53% to 61% choosing the lowest expense fund has the highest performance of all alternatives in the next period, with the number of funds available averaging 10 funds. Taking into account the factors affecting pre-expense return improves performance but given the much larger effect of expenses, the improvement is very small and nowhere near statistically significant.

Finally, we examine the choice between two alternatives: the lowest cost index fund and the lowest cost exchange traded fund. If one were always to select the ETF each period, the return would be 9.4 basis points per year higher for institutional investors and 19.3 basis points per year higher for retail investors than always selecting the lowest cost index fund. However, if the investor followed a strategy of selecting either the index fund or ETF each period, whichever had the lower expenses, the institutional investor would be better off by 15 basis points per year and the retail investor by 24 basis points. Clearly, expense ratios allow the investor to make better choices when selecting a passive investment.

The complete paper is available for download here.

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