ETF Due Diligence: Chasing Quality, Not Performance

November 03, 2017

[Editor’s Note: The following originally appeared on FactSet.com. Elisabeth Kashner is director of ETF research and analytics for FactSet.] 

The Wall Street Journal lit a fire in the mutual fund due diligence world last week, publishing "The Morningstar Mirage," a 19-page analysis of Morningstar’s five-star rating system. In it, the WSJ charged that “funds that earned high [Morningstar] star ratings attracted the vast majority of investor dollars. Most of them failed to perform.” The WSJ continued, “On the average, five-star funds eventually turn into merely ordinary performers.”

The cost of performance-chasing is staggering. ETF investors are not immune. Just ask the crowd that invested $8.3 billion in the WisdomTree Europe Hedged Equity Fund (HEDJ-US) between January 1, 2015 and June 30, 2016. 

The cumulative net return of HEDJ during that time was a mere 0.11%, while AUM increased from $5.6 billion to $10.6 billion.

 

 

Over that 18-month period, buy-and-hold investors earned .07% per year. On a dollar-weighted basis, investors lost 21.58% per year. Dollar-weighted returns show the average experience of the “hot money”—the investors who created and redeemed shares of the fund during the period. Dollar-weighted returns take into account the rate of return to every new investment (inflows) and sale (outflows).

That 21.65% performance gap between buy-and-hold and tactical trading in HEDJ shows just how painful performance-chasing can be.

In March of this year, I compared fund returns vs. investors’ returns for 60 ETFs in the U.S. total market, U.S. large-cap, and Developed Ex-U.S. total market segments, for a five-year period. That’s all the “smart beta” and a few representative vanilla funds that had a five-year track record, with no change in investment strategy that might cloud the results. 

The results were clear. Buy-and-hold won out in 53 of the 60 funds. Dollar-weighted investors underperformed their buy-and-hold counterparts by an average of 1.7% per year, per fund.

How Performance-Chasing Falls Short

Performance-chasing often ends badly, because few funds can outperform quarter after quarter, year after year. As Morningstar explained to The Wall Street Journal in a written response to its article, “Reversion to the mean is a powerful force that can affect any investment vehicle.” Performance history, even when risk-adjusted, is not a reliable predictor of future results.

Morningstar CEO Kunal Kapoor also wrote in the rebuttal, “Our research finds that the star rating points investors toward cheaper funds that are easier to own and likelier to outperform in the future. These are qualities that correspond with investor success.”

We agree that fund quality—low cost and low operational risk—are predictable factors that influence long-term fund performance, because every penny that leaks out of an investment account is a penny that can’t provide future returns. 

Fund quality is mostly a function of costs—both operational and trading—but it also includes some risk assessment that measures the probability of rare, high-impact events that potentially have severe consequences. The biggest operational costs are tracking difference and trading charges, which can be measured by the bid-ask spread. ETF closure is an example of a severe negative event, as is ETN issuer default.

 

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