Improper Use of ETFs Is Lowering Returns

Despite the advantages that exchange-traded funds offer, individual investors who use them are not realizing better returns, primarily due to timing decisions.

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Despite the advantages that exchange-traded funds (ETFs) offer, individual investors who use them are not realizing better returns. Rather, the opposite occurs—users of ETFs tend to incur worse performance.

ETF investors reduced the net return of their portfolio from 3.91% to 2.74% for the benchmark MSCI World Index. Timing decisions involving the trading of ETFs accounted for 0.77 of the 1.16 percentage point drag. Though trading costs had an impact, the study’s authors found that returns were hurt primarily by timing decisions after analyzing portfolios from the standpoint of gross returns.

ETF investors also hurt their returns through their choice of funds. The actual ETFs invested in resulted in annual returns that were 1.69 percentage points lower relative to what would have been realized through the buying and holding of an MSCI World Index ETF. The drag was mostly attributable to poor ETF selection. Unsurprisingly, this behavior also worsened the investors’ diversification.

The authors of the study did not mince words when summarizing results. They opined, “There is no distinct group of investors whose portfolio performance is positively affected by the use of ETFs, no matter which measure (performance, timing, selection or relative Sharpe ratio loss) or sort (turnover, portfolio value, or relative Sharpe ratio loss) we examine.”

The study is based on an analysis of brokerage data for nearly 7,000 German investors for the period of August 2005 through March 2010. All of these investors had previously refused free financial advice offered to a random sample of the broker’s customers. Within this group, approximately 1,100 investors traded at least one ETF during the sample period.

It should be noted the study’s authors did not blame ETFs for the underperformance. Just the opposite. They wrote, “We also find that no groups will lose by investing in the right MSCI ETF.” Rather, they find fault in the way ETFs are used. They found investors making the same mistakes with ETFs as they make with other securities, such as trading too frequently. The study’s authors believe investors would do better by buying and holding globally diversified ETFs, such as the Vanguard Total World Stock (VT), instead of frequently trading and attempting to pick the “right” ETF.

Source: “Abusing ETFs,” Utpal Bhattacharya, Benjamin Loos, Steffen Meyer and Andreas Hackethal, Journal of Finance, forthcoming.