The Dark Side of Exchange-Traded Funds

Many investors think that low-cost exchange-traded funds are better choices than ordinary, old-fashioned, open-end mutual funds. And they have a point. With most broad-based index ETFs, you know the fund will match its benchmark, minus piddling expenses. However, open-end funds generally lag their benchmarks because they charge outrageously high fees. Only suckers buy them.

Or maybe not. A fascinating study by Mark Hulbert, editor of the Hulbert Financial Digest, which tracks the performance of investment newsletters, finds that ETF investors may be the bigger losers.

Hulbert tracked the model portfolios of newsletters that offer both ETF portfolios and portfolios that invest solely in open-end funds. In 2013, the portfolios consisting of open-end funds returned 20.9%, on average. That was 3.0 percentage points ahead of the average ETF portfolio.

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ETF portfolios likewise lagged over longer periods. For the five years that ended last December 31, the average open-end fund portfolio returned an annualized 14.2%, beating the average ETF package by an average of 2.6 percentage points per year. Over the past ten years, the open-fund portfolios returned an annualized 6.9%, an average of 2.0 percentage points per year better than the ETF portfolios.

It’s an elegant little study. By looking at the returns only of advisers who offer both ETF and open-end fund portfolios, Hulbert provides a meaningful test of how advisers do at picking ETFs compared with how they do picking open-end funds.

What’s going on here? ETFs usually charge much lower prices than open-end funds. Why don’t ETF portfolios do better?

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Hulbert speculates that some of ETFs’ advantages can all-too-easily turn into disadvantages. ETFs can be traded all day long, rather than just once a day like open-end funds. They can also be sold short—that is, you can bet that they’ll fall in price. Those qualities, Hulbert suggests, have tempted advisers to trade too often and to short ETFs. Neither strategy has been helpful during the bull market, which celebrates its fifth birthday on March 9.

I think Hulbert has part of the answer. The bigger part, I believe, has to do with the incredible variety of ETFs. Yes, there are far more open-end funds than ETFs. But most open-end fund managers toil at beating one of the broad market averages, such as Standard & Poor’s 500-stock index, which focuses on large U.S. companies, or the Russell 2000 index of small companies. Most managers fail, but they don’t typically get killed; over long periods, most of them finish a small amount behind their benchmark on an annualized basis.

ETFs, on the other hand, boast a mind-numbing list of narrow and esoteric strategies. You think the Russia-Ukraine crisis will be resolved quickly? SPDR S&P Russia ETF (symbol RBL) has your number. You may not be able to find Indonesia on a map, but you can invest in small Indonesian firms via Market Vectors Indonesia Small-Cap ETF (IDXJ). Back in the ’60s, I used to listen to the music of a rock band called Rare Earth. Today, I can invest in Market Vectors Rare Earth/Strategic Metals (REMX), which tracks an index of stocks involved in producing, refining and recycling these metals and minerals.

ProShares offers a variety of ETFs that let you short indexes or even get double or triple the daily return of an index. “Geared (Short or Ultra) ProShares ETFs seek returns that are either 3x, 2x, -1x, -2x or -3x the return of an index or other benchmark,” says ProShares’ Web site.

Think of funds as an investing toolbox. The toolbox containing open-end funds is filled mainly with tools you know how to use: hammers, wrenches and screwdrivers. Usually, the worst you’ll do with these tools is hurt a finger. The ETF toolbox, meanwhile, contains a whole lot of tools that can blow up your house. And, by the way, a lot of these strange and dangerous ETFs cost almost as much as open-end funds.

None of this is to defend open-end funds. Almost all of them do charge too much and, consequently, lag their benchmarks. Indeed, the open-end fund portfolios that Hulbert tracked fail to match the S&P 500 over any period except the ten-year stretch through 2013.

ETFs have a lot to commend them. But stick with broad-based, low-cost ETFs from companies such as Vanguard, as I recommend in my column on the Best ETFs for 2014. Don’t be seduced into using ETFs to slice the markets into tiny pieces—or into trading them. As Hulbert shows, ETFs can be hazardous even in the hands of professionals.

Steve Goldberg is an investment adviser in the Washington, D.C., area.