Following is the second in a two-part series on mutual and exchange-traded funds.
In part one of my series, I explained the difference between mutual funds and exchange-traded funds (ETFs). The question remains: Which makes a better investment?
Craig Israelsen, associate professor at Utah Valley University, recently attempted to quantify the performance difference between mutual funds and ETFs by creating two portfolios: one using only ETFs, the other containing only mutual funds.
Each portfolio comprised 12 asset classes: large-cap U.S. stocks, mid-cap U.S. stocks, small-cap value U.S. stocks, non-U.S. developed market stocks, non-U.S. emerging market stocks, real estate, natural resources, commodities, U.S. bonds, U.S. inflation-protected bonds, non-U.S. bonds and cash.
Each asset class was weighted equally at 8.33 percent of the total portfolio, and each portfolio was rebalanced at the end of each year over a three-year period.
To make the comparison as objective as possible, Israelsen selected the largest ETF and the largest fund (in terms of total assets) to represent each of the above asset classes in the two portfolios. He did not attempt to identify the best-performing ETF or mutual fund. The returns as measured were net of expense ratios, and there was no attempt to take into account taxes, trading costs or inflation. All data came from Lipper Mutual Fund information.
The results appear on the accompanying chart. Although the ETF portfolio reported slightly higher tax efficiency and a considerably lower aggregate expense ratio (0.22 percent versus 0.63 percent), the two portfolios produced nearly identical returns in the three years from 2010 through 2012 (8.13 percent average annual return for the ETF portfolio and 8.23 percent for the mutual fund portfolio).
Of course, this analysis only covered a three-year period, a very small sample from which to infer longer-term investment performance. And there was a pretty big disparity in some of the individual asset classes, in particular international fixed income, where the mutual funds trounced the ETFs, and in natural resources, where the reverse occurred.
Nonetheless, my conclusion from this analysis is that it’s more important to focus on building a well-diversified portfolio than trying to find the “best” mutual fund or ETF. Other studies have borne this out as well.
Israelsen also discovered that the performance spread among ETFs within each asset class tended to be smaller than that of the mutual funds. This, of course, can be attributed to the fact that most ETFs are index trackers, whereas many mutual funds are actively managed and have much more flexibility.
As to which is better, mutual funds or ETFs, the answer would appear to be neither, as long as you use a sufficient number of asset classes and an appropriate asset allocation model for your investment portfolio.