Beyond The Abstract: Morgan Stanley Report Lists ETF Pluses

June 25, 2008

New report describes advantages of ETFs versus mutual funds and includes interesting data.


Paul Mazzilli's research group at Morgan Stanley released a report on an issue that comes up frequently on—exchange-traded funds versus mutual funds.

"Exchange-Traded Funds: ETFs Provide Attractive Alternatives To Open-End Mutual Funds," dated June 4, 2008, covers a lot of familiar territory for people who know their ETFs.

But the document is at the very least a solid primer for investors who are new to ETFs. Moreover, a lot of that familiar territory is backed up with some interesting data nuggets that will be useful to investors and other market participants at all levels of knowledge.

ETF Advantages

The best example of this is the stats in the table that accompanies the report's assertion that ETFs are among the lowest-priced registered investment products. Actively managed domestic equity mutual funds have average expenses totaling 145 basis points; indexed domestic equity mutual funds have average expenses of 70 bps. Domestic equity ETFs, however, have average expenses of just 53 bps, with a weighted average of 29 bps.

The range for domestic equity ETFs is a rather wide 7-95 bps. Major market U.S. ETFs have an even lower average of 34 bps in fees, with a weighted average of just 15 bps.

The gap is even more significant when you move on to international funds. Actively managed international mutual funds charge an average of 167 bps, while indexed international mutual funds charge an average of 95 bps. International ETFs charge an average of 55 bps, and a weighted average of 48 bps.

The report also discusses the usefulness of in-kind transactions with regard to avoiding capital gains. A table cited in this section shows the capital gains distributions as a percentage of NAV for the S&P 500 SPDR (AMEX: SPY) and the average S&P 500 index mutual fund from 1993 to 2007. Since 1993, SPY has averaged 0.01%—and that was entirely due to 1996, when the fund had a capital gains distribution that was 0.12% of NAV. Meanwhile, the average for S&P 500 index mutual funds was 1.67%, and spanned a range from 0.11% in 2002 to a whopping 4.76% in 1995.

However, when I was reading this I had to remind myself that since these are average numbers, there could be quite a few S&P 500 index funds that didn't have capital gains anywhere near the average. (I don't have any stats for the Vanguard 500, for example, but I'd be willing to bet that any capital gains distributions it might have had during that time period were more comparable to those of the SPY than the average S&P 500 index fund.)

Despite the arrival of actively managed ETFs, most ETFs are still tied to indexes, so it's entirely appropriate that the report gives some updated statistics from Lipper on the performance of actively managed funds versus their benchmarks.

For the 10-year period ended December 31, 2007, 59% of large-cap blended funds underperformed their benchmark. A stunning 71% of large-cap value funds underperformed their benchmarks, while just 34% of large-cap growth funds did so.

But contrary to popular belief, small-cap managers didn't exactly shine. Seventy-three percent of small-cap blended actively managed funds underperformed their benchmarks for the 10-year period, and while large-cap growth managers had respectable performances, 64% of small-cap growth funds underperformed their benchmarks. Active small-cap funds did relatively well in value, however, with only 65% of those funds underperforming their benchmarks.

For active bond funds, the track record is even worse: Some types of active bond funds—intermediate-term corporate bond funds and long-term government bond funds - had a 100% failure rate in terms of beating their benchmarks. Short-term high-yield active fixed income-funds had the best performance versus their benchmarks—only 75% of them failed to outperform.

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