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Some Interesting Data from the 2014 Investment Company Fact Book

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The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs) and unit investment trusts (UITs). Members of ICI manage total assets of $17.1 trillion and serve more than 90 million shareholders. Every year since 1961, it has published the “Investment Company Fact Book” which helps researchers identify trends in the investment industry. One trend that is clearly noted in the 2014 edition is the ascent of indexing. The two charts below show the growth of both index mutual funds and ETFs for the six calendar years from 2008 to 2013.

While ETFs experienced a higher percentage growth in assets compared to index mutual funds (222% vs. 188%), the most startling difference is the higher percentage growth in the number of funds (73% vs. 4%). It would appear that there is now a mini-industry centered on facilitating the start-up of ETFs. Recall that the primary difference between a mutual fund and an ETF is that while the former trades only once at the end of the day based on net asset value, the latter trades throughout the day based on market value which may diverge from net asset value. John Bogle, the father of retail indexing, has warned investors that what appears to be an advantage of ETFs may in fact be a disadvantage because they encourage investors to trade unnecessarily. A recent academic paper out of Germany titled “The Dark Side of ETFs” strongly supports Mr. Bogle’s assertion.

The authors analyzed the performance of 1,087 German users of ETFs from August, 2005 to March, 2010. They found that adding ETFs worsened their performance, and the results were found to be statistically significant. The net return on the ETF part of the portfolio was 5.4%, almost exactly half the return on the non-ETF part of the portfolio at 11.0%. Adding insult to injury, the standard deviation of the ETF portion was nearly four percentage points higher than the non-ETF portion (25.5% vs. 21.6%). The authors conclude that ETF investors cause themselves harm that is attributable to poor market-timing:

“We find that the portfolio performance of individual users relative to non-users of ETFs worsens after use. As these securities make market timing easier, we investigate whether this is primarily due to bad market timing. Our answer is yes. We find that the improvement in security selection caused by the use of ETFs is frittered away by bad market timing.”

On the other side of the coin, however, a study by Vanguard Research found that the differences in trading activity by ETF investors vs. mutual fund investors was largely explained by the demographic differences between the two groups. ETF investors have a stronger tendency to be younger males with higher risk portfolios who log into their accounts on a daily basis. Thus, it should not surprise us that we see higher trading activity from holders of ETFs, but it may not be correct to say that ETFs cause the higher trading activity.

Naturally, we at Index Fund Advisors are quite pleased to see the continued growth of indexing, regardless of whether it is from mutual funds or ETFs. We will continue to do our utmost to educate investors in the proper use of these investment vehicles.