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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 IndexUniverse.com. "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.

The largest, most popular ETFs mimic major indexes: the SPDR, tracking the S&P 500; PowerShares QQQ, tracking the Nasdaq index of 100 large non-financial companies, especially techs; iShares MSCI Emerging Market Index ETF; and iShares Russell 2000 Index of smaller companies.

ETFs for industry sectors gain or lose investors as market sentiment changes. Right now, the Financial Select Sector SPDR is getting a lot of play. Sector ETFs simplify your life because you don't have to research each stock separately, said Tom Lydon, editor of ETFTrends.com and co-author (with my Bloomberg colleague John Wasik) of "IMoney: Profitable ETF Strategies for Every Investor."

Beyond performance, ETFs have two other things going for them. They charge lower annual fees than managed funds, and, in most cases, they offer an edge to taxable investors. ETFs rarely distribute taxable capital gains during the time you hold the investment, as many traditional funds do. You usually don't have to book any gains until you sell your shares.

In one investment sector, the major ETFs fall behind. They usually don't beat low-cost traditional index funds, such as those offered by the Vanguard Group and Fidelity Investments. These funds not only charge low fees, but you can add to them, reinvest dividends and make withdrawals without paying brokerage commissions or other trading costs.

Where ETFs shine is against the higher-cost managed mutual funds.

Scott Burns, director of ETF analysis at Morningstar, said indexing usually grabs more market share during slowdowns, when managers underperform. But when stocks turn up again, a certain percentage of retail investors go back to chasing funds they think can beat the market. "To be an index investor takes a great amount of discipline," Burns said. But worth it, in the end.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.

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