A Brave New World

July 01, 2005

This study compares the returns of exchange-traded funds (ETFs) and index funds against the performance of the most commonly tracked equity indexes. Of particular interest is the differential in cost (i.e., the expense ratio) and tax efficiency between index funds and comparable ETFs, in as much  as low costs and tax efficiency are commonly cited advantages of ETFs (Chamberlain and Jordan, 2004).

At year-end 2004, there were 152 ETFs in the Morningstar Principia database, with total assets of more than $222 billion. The largest, and oldest, ETF is the Standard and Poor's Depositary Receipts Trust 1, or SPDR, which is designed to track the S&P 500 Index. Since its inception in January 1993, the SPDR has gathered in excess of $52 billion in assets.

Fund providers have steadily introduced new ETFs over the course of the past decade, as shown in Figure 1.

To avoid anomalous results based on limited data, this study focused on ETFs with at least a three-year performance history. Of the 152 ETFs on the market as of December 31, 2004, 97 qualify. This subset had a total of $199 billion in assets, representing about 90 percent of all ETF assets.

There were no bondindexed ETFs with a three-year performance history as of December 31, 2004, hence none were included in this analysis.

During the past decade, ETFs have entered into a market dominated by mutual funds, and particularly by index funds. At year-end 2004, there were 527 index funds (equity and bond) in the Morningstar Principia database, with over $504 billion in total net assets. The oldest currently existing index fund in the database is the Vanguard Small Cap Index Fund, which was brought to market in October 1960 (though it was not always an index fund). The next index fund (and at the time the first retail index mutual fund), the Vanguard 500 Index Fund, didn't arrive until August 1976, but is now the largest mutual fund (let alone index fund) in existence, with over $80 billion in net assets.


Many mutual funds now have multiple share classes, such as A shares, B shares, C shares, I shares, K shares, etc. In this study, only one share class (the class with the largest asset base) was included in the analysis-and is referred to as a "distinct" fund. Failing to remove redundant share classes over-represents funds with multiple share classes and skews the data. Of the 527 index funds, there were 213 distinct funds with at least a three-year performance history as of year-end 2004. These funds had a total of $380 billion in net assets, or nearly 76 percent of total index fund assets. As with ETFs, index funds began proliferating in the mid-1990s (see Figure 2).

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