ETF Truths From Morningstar Gap Survey: Allan Roth

Does the survey show mutual fund index investors are more disciplined than ETF index investors?

Decades ago, I was taught that we can’t time the market.

I stand corrected: We're good at timing the market poorly. My belief is supported by Morningstar's latest Mind the Gap study, led by the firm's chief rating officer, Jeff Petak, who concludes thusly:

"We estimate that the average dollar invested in US mutual funds and exchange-traded funds earned 6.3% per year over the 10 years ended Dec. 31, 2023. That is approximately 1.1% per year less than the average fund's total return over the same period assuming an initial lump-sum purchase. The 1.1% 'gap' is explained by the timing of investors' purchases and sales of fund shares."

Below are the findings by category:

10-Year Returns ending 12/31/23

The above includes both open-ended mutual funds and ETFs. The usual findings persist in that the gap is larger the narrower the category. The largest gaps are in nontraditional equities and sector equities. The smallest gap is in allocation funds with only a 0.4 percentage point shortfall. Allocation funds are the widest as they include multiple asset classes like stocks and bonds.

We love alternative asset classes with the hopes that correlations with stocks are low so they will zig when the markets zag. But fund returns are virtually zero, leaving investors with the same outcome overall as gambling in Las Vegas. One needs more than low correlation; they must also have return expectation to compensate for the risk.  

Are Mutual Fund Index Investors More Disciplined?

How did ETF investors do compared to mutual funds? ETFs have lower costs and more indexing strategies so it’s not surprising that their 6.9% annualized return bested mutual funds by 0.8 percentage points. Quite surprisingly, ETF investors had a slightly wider gap than mutual fund investors (1.1 percentage points for ETFs vs. 1.0 percentage points for mutual funds).

Could it possibly be that investors in active mutual funds are more disciplined than those in ETFs? The answer is a resounding no. The gap in active funds was 1.2 percentage points while index investors had a lower 0.8 percentage point gap. And, of course, index funds themselves earned 7.6% annually vs. only 5.5% for active funds.  

The real surprise came from index fund investors. Those indexers in mutual funds had only a 0.2 percentage point gap while ETF index investors had 1.1 percentage point gap. Yes – mutual fund index investors showed far more discipline than ETF index investors.  

Are there too many narrow ETFs such as sector ETFs with a 2.6 percentage point gap? Or perhaps ETFs are now so easy to trade. I suspect both. It may also be the prevalence of index funds within target date retirement mutual funds in defined contribution plans which do rebalance.

Lessons for ETF Investors

ETFs are generally a better vehicle than mutual funds with lower fees and greater tax-efficiency. But this doesn’t mean investors can’t misuse ETFs. Here’s my advice:

Broader is better – avoid narrow ETFs. See Cathie Wood’s Ark Innovation Fund (ARKK).

Buy and hold is good but rebalancing is even better. Fund investors on average underperform but investors overall earn the market return before costs. Buy those broad funds when they are on sale such as the 35% off sale in the 33 days ending March 23, 2020 when Covid hit.

Set an asset allocation and stick with it.  

Keep fees low and discipline high.

Using these lessons will assure you will not own a top ten performing ETF. But, unless human nature changes suddenly, you’ll be getting to your financial goals much faster and likely to earn far more than investors who don’t mind the gap.  

Use ETFs to invest, not to speculate. When you get an irresistible urge to buy that top performing ETF with the charismatic fund manager, let the urge pass.