Financial experts have debated for years the merits of passively managed mutual funds versus exchange traded funds (ETFs) as investment tools. A new study from the University of Iowa finds ETFs have several advantages for investors over mutual funds.
The study finds that investor service costs charged by passively managed mutual funds significantly hinder their performance when compared to ETFs. Researcher Tong Yao, a professor of finance at the Tippie College of Business, said passive funds underperform their ETF counterparts by 42 basis points in annualized returns.
He said the bulk of that underperformance is the result of investor service costs and the need to maintain cash on hand to pay for redemptions, also known as cash drag. About 78% of the additional costs come from fees that pay for administration, record keeping, and regulations mandated by federal agencies. An additional 15% of the underperformance is caused by cash drag, as cash earns little to no return for investors.
Yao said that unlike mutual funds, which hold equities, ETFs are equities themselves that are traded on stock exchanges, so investors are responsible for transaction costs. He said that while ETFs charge these costs, mostly to cover creation and redemption fees, they are far less than those charged by mutual funds.
The study looks at how expense costs of 265 passive mutual funds affect their performance when compared to ETFs that follow the same index and are managed by the same financial services firm. For instance, the Vanguard S&P 500 index fund was compared to Vanguard’s S&P 500 ETF. It found the average annual expense ratios for passive mutual funds is .45%, more than double the ETF average annual expense ratio of .21%.
Yao said that ETFs also offer tax advantages over mutual funds, though the study did not take those into account.
For retirement savers, he said this means ETFs are especially well-suited for IRAs, as more of the investor’s money can be used for earnings instead of paying fund fees.
But Yao said the cost differences don’t necessarily mean ETFs are better for every investor. For those who are investing only a small amount of money or who have short or medium investment horizons, the services provided by the mutual fund firm does provide a useful premium.
The study also tracked actively managed mutual funds from the same company and found that their stock returns outperform passively managed funds by 31 basis points. However, active funds charge fees that are 60 basis points higher than those charged by passive funds, so their net return is actually below the return of passive funds.
The study, “The effect of investor service costs on mutual fund performance,” was published in the journal The Financial Review. It was co-authored by George Jiang of Washington State University and Gulnara Zaynutdinova of West Virginia University.
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