By Dan Hallett on September 25, 2012
For years I’ve been hearing from individual investors and financial advisors who are disappointed with their meagre long-term performance. This jibes with calculations I completed four years ago, which showed that Canadian mutual fund investors largely missed out on the available risk premium over nearly 15 years prior to the worst of the last bear market (as illustrated in this chart).
As a result, many have cast their mutual funds aside in favour of cheaper exchange-traded funds (ETFs) expecting higher returns. But I’m convinced that in 2022 or 2027, similarly-disappointing performance figures will be printed about ETF investor returns.
I have been saying for years that ETF sponsors have adopted all of the mutual fund industry’s bad habits. ETF sponsors learned that launching more product was the surest path to growing assets. In the spring of 2009, there were about 80 Canadian-based and more than 800 U.S.-domiciled ETFs. Today, those numbers are closer to 250 and 1,500, respectively. Since spring 2009, Canadian ETF assets have tripled while U.S. ETF assets more than doubled.
Another tip ETF sponsors picked up was to launch funds covering hot market segments or themes. Mutual fund investors have tried hard to forget funds bearing monikers like Boomernomics and e-commerce. But ETF investors will be able to reminisce about even more creative names a decade from now.
Some of my favourites include Risk-On/Risk-Off, Global Warming and 2x Gold Bull/S&P 500 Bear. Those are U.S. based products but Canadian sponsors haven’t slacked off. Some of our more eccentric offerings include Silver Yield ETFs, Inverse VIX and Global Water. While these may be interesting themes, I believe investors are worse off for having access to such specialized products because these are largely speculative plays.
The more specialized the product the more volatile it’s likely to be. In turn, I suspect that investors will not only be lured into poor timing decisions but will trade such vehicles more frequently. If history and past research are any guide, this will lead to disappointing returns.
Six vs a half-dozen
Since fees were a significant barrier to mutual fund investors’ long-term success in the past, ETF fans argue that their lower fees should leave more jingle in investors’ jeans in the future. Perhaps but only for a disciplined few. Research on individual stock trading doesn’t support this notion.
Successful investing requires discipline. In my view, success with ETFs requires more discipline than with mutual funds given that ETFs are so easy and cheap to trade – like stocks. Brad Barber and Terrence Odean’s terrific research on individual stock trading found that investors generally lack discipline and incur significant trading costs while trading away potential gains.
In a 1999 paper – The courage of misguided investors – Barber and Odean found that more frequent trading lead to significantly lower returns. In a separate study – Just how much do individual investors lose by trading? – Barber and Odean found that U.S. stock investors effectively traded away 2% annually through frequent trading (thereby generating lots of commissions for brokers) and making poorly timed trades (effectively giving away 1.5% to ‘smarter’ institutional investors).
Those are studies on individual stock trading but I believe that investors behave similarly with more specialized ETFs. My expectation, then, is that even though ETFs are cheaper to hold, investors will simply trade away that cost advantage just like stock investors have done. Management fees charged to mutual funds reduce returns just the same as heavy
trading slices returns through brokerage commissions and ill-timed trades.
Focus on behaviour, not product
This is not an ETF-vs-mutual-fund issue. The product is meaningless in this discussion. I’ve focused on mutual fund investor returns because the data is abundant and clean. And since investor returns in mutual funds have been poor, the product gets all of the blame. It deserves some of it – mainly for high costs – but not nearly all of it.
Investor behaviour was a significantly factor in mutual fund investors’ past low returns. Based on the Barber and Odean studies – and my observation that investors trade more frequently when barriers to trading are low – I expect behaviour to be an even larger performance drag as the number of exchange traded products grows and niche funds continue to proliferate.
And in ten or fifteen years, I’m willing to bet that long-term studies on individual ETF trading and returns will show the kind of disappointment that mutual fund investors are voicing today. But believe me, I would love to be proven wrong.