Exchange-Traded Funds Beat Active Managers

By Jane Bryant Quinn
Sunday, January 18, 2009

The exchange-traded-fund industry has the enemy in its sights: the active manager who runs a traditional equity mutual fund. When they first appeared in the marketplace, ETFs talked up such virtues as lower costs, tax advantages and ease of trading. Now, after the Dow Jones industrial average's worst year since 1931, they're going in for the kill.

"Active managers say they'll protect you when the market falls by getting ahead of it," said Lee Kranefuss, chief executive of Barclays Global Investors' iShares business. "That promise is hard to deliver on." ETFs are not only cheaper, he said, but they also outperform the managers.

An ETF is a mutual fund that you buy and sell through a brokerage account, like an individual stock. Most ETFs are index funds -- meaning they track the performance of a particular market, or slice of a market, rather than try to exceed it.

In theory, active managers should beat indexes because their funds can build up cash during a market drop. They're also supposed to be able to pick the stocks that will hold up during declines. That's one of the things you pay them for.

But they're not earning their pay. Last year, 58 percent of actively managed funds lost more in value than the benchmark against which they measure themselves, according to Morningstar. Small-cap managers, who are supposed to be especially nimble, had a particularly bad year: Seventy-two percent of them fell behind their benchmarks.

The numbers get worse when you compare the managers' performance with the Standard & Poor's 500-stock index. Among large-cap U.S. funds, 62 percent lagged behind the S&P 500 in 2008, as did 63 percent of all U.S. diversified equity funds.

Most managed funds trail the indexes in the first phase of a recovery, too. As an example, look at what happened in the 12 months after October 2002, the bottom of the last bear market. Seventy-eight percent of U.S. managed equity funds did worse than their benchmarks. You are paying your managers to miss.

Investors are catching on. They pulled $128.7 billion out of managed equity mutual funds in the first 11 months of 2008, according to the Investment Company Institute in the District, but they didn't give up on stocks entirely. During the same period, they put $20.8 billion into traditional index funds. Exchange-traded products attracted $133 billion.

"Anytime the market is struggling, investors are more likely to notice the drag on performance caused by the fees active managers charge," said Jim Wiandt, publisher of "That pushes them toward indexing in general and ETFs in particular," he said.

In December, ETFs accounted for 38 percent of all equity trades by dollar value on the NYSE Arca trading platform, up from 32 percent in the third quarter. A majority of the volume came from large investors, including institutions and hedge funds, Wiandt said.

Retail investors are playing, too, especially for year-end tax planning. They were selling traditional mutual funds, booking the losses and staying in the market by buying similar ETFs.

Christy White, a principal of the consulting firm Cogent Research in Cambridge, Mass., said ETFs are attracting Generation X investors, now in their 30s and 40s, who tend to be more self-directed than older investors. ETFs also interest high-net-worth investors, who use the funds in place of individual stocks for broad exposure to market segments. As any money manager can tell you, picking stocks is hard.

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