A Brave New World

July 01, 2005

NASDAQ-100 Index

For the NASDAQ-100 Index, the asset-weighted average annualized return of the seven index funds trailed the index by 96 basis points over the three-year period ending December 31, 2004. That's remarkable considering the average expense ratio of 114 basis points-the funds managed to pick up 18 basis points through performance.

The NASDAQ-100 ETF (QQQQ) turned in a stronger performance, trailing the benchmark by just 20 basis points. This performance was entirely explained by the fund's expense ratio (20 basis points). The tax cost ratio between the ETF and the  index funds was identical.


The Morgan Stanley Capital International EAFE Index is tracked by 16 distinct funds and one ETF. The iShares ETF posted a higher return than the index funds by a margin of 48 basis points. Surprisingly, the iShares ETF was within four basis points of the return of the EAFE index, or 31 basis points better than expected given its expense ratio of 35 basis points. The asset- weighted return of the 16 index funds was 52 basis points lower than the raw index, which nearly coincides with the average expense ratio of 53 basis points. Finally, the ETF had a 16 basis point better tax cost ratio.


To summarize, among the nine equity indexes analyzed, ETFs that tracked them had a lower expense ratio than corresponding index funds in every case. ETFs also had superior threeyear returns in seven out of nine cases. Index funds that track the S&P 500 and S&P MidCap 400 demonstrated superior assetweighted performance compared to the corresponding ETFs.

On the tax question, ETFs also came out generally on top. ETFs had better tax efficiency in four out of nine cases, and in four cases, the tax efficiency of ETFs and index funds were essentially the same. In only one case (the S&P 500/Barra Growth Index) was the tax efficiency of index funds clearly superior to that of the corresponding ETF.

Equity Index 3-Year Return (percent) Best-Performing Index Fund 3-Year Return (percent) Best-Performing Exchange-Traded Fund 3-Year Return (percent)
Wilshire 5000 5.47 Vanguard Inst Total Stock Index 5.54 Vanguard TSM VIPERs 5.36
S&P 500 3.58 California Investment S&P 500 3.62 iShares S&P 500 3.49
S&P 500/Barra Value 6.46 Schwab Instl Select LC Value 6.33 iShares S&P 500/ Barra Value 6.27
S&P 500/Barra Growth 0.63 Maxim Growth Index 0.18 iShares S&P 500/Barra Growth 0.44
S&P Midcap 400 10.51 Thrivent Mid Cap Index A 10.34 iShares S&P MidCap400 10.32
S&P Smallcap 600 13.26 Vanguard Tax-Managed Small Cap R 13.33 iShares S&P SmallCap 600 13.11
S&P Smallcap 600/Barra Value 13.86 Schwab Inst Sel Small Value Index 13.81 iShares S&P 600/Barra Value 13.61
S&P Smallcap 600/Barra Growth 12.35 ProFunds Small Cap Growth Inv 9.13 iShares S&P 600/Barra Growth 12.07
Russell 2000 11.48 Northern Institutional Small Index A 11.40 iShares Russell 2000 Index 11.33
NASDAQ-100 1.10 California Inv Nasdaq100 0.71 Nasdaq 100 Trust 0.90
MSCI EAFE 11.89 Laudus Ros Intl Eq Instl 12.59 iShares MSCI EAFE 11.85
Figure 13. The Best of the Trackers (Morningstar data as of 12/31/04)

In Figure 13, we list the best performing index fund and ETF relative to each of the nine equity indexes, based on the three- year performance window ending December 31, 2004. For this particular table we also included the S&P SmallCap 600/Barra Value and Growth indexes, and the corresponding best performing index fund and ETF. It is interesting to note that the three- year return of the best performing index fund was generally higher than the return of the best performing ETF. This suggests that some index funds can, and will, compete with the lower cost structure of ETFs.


Chamberlain, Mark and Jay Jordan, "An Introduction to Exchange-traded Funds", Barclays Global Investors Services, http://www.ishares.com/material_download.jhtml?relativePath=/repository/material/downloads/intro_to_etfs.pdf


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