ETF returns lag those of other vehicles, mostly because of bad market timing.
Vanguard Group founder John Bogle created the first index funds available to individual investors in 1976, and ever since then he’s been a tireless champion of their use.
Given that passive ETFs can provide advantages—such as lower costs and greater tax efficiency—over index mutual funds, you might think that Bogle would be a big proponent of their use as well. Yet he warned investors that ETFs had a dark side. The ability to frequently trade them could tempt investors to do so far too often.
In fact, he warned investors that ETF trading is “no way to invest.” Bogle also warned investors against using ETFs that focus on narrow sectors of the market. And he warned that leveraged and inverse ETFs are where the “fruitcakes, nut cases and lunatic fringe” can be found.
So, is Bogle right to be concerned about individual investors misusing ETFs?
To answer that question, the authors of the October 2013 study, “The Dark Side of ETFs,” used data from one of the largest brokerages in Germany. The study—by Utpal Bhattacharya, Benjamin Loos, Steffen Meyer, Andreas Hackethal and Simon Kaesler—covered the period from August 2005 through March 2010. German use of index-linked products is similar to that of the U.S., representing about 20 percent of the market in both countries.
Within that market, however, the use of index mutual funds and passive ETFs in the U.S. is split relatively evenly, while passive ETFs dominate the German market with an 84 percent share. It’s also worth noting that in Germany, while the Top 10 benchmark indexes constitute more than 60 percent of the assets under management in ETFs, 207 other benchmark indexes are available in ETF form. This provides investors there with plenty of opportunity to try and time the markets.
The study’s authors derived their data from about 7,000 self-directed individual investors—meaning the results are not distorted by third-party advice—and excluded investors who also used index mutual funds. About 1,000 of the investors used ETFs; the remainder did not. By separating these two groups, the authors were able to make a number of significant comparisons.
The following is a summary of their findings: