Exchange-traded fund (ETF) investors are losing out compared to counterparts in similar index strategies via unlisted products likely due to over-trading, according to a new Morningstar study.
The annual Morningstar ‘Mind the gap’ analysis of US investor behaviour found a marked discrepancy in individual returns between passive-style ETFs and managed funds.
In the study, Morningstar measures the real average return investors received each year – based on product cash flows – against the reported headline performance of funds.
“For the first time, we compared the gaps of open-end funds with exchange-traded funds, finding they were roughly the same at about a negative 1% gap per year,” the 2024 report says.
“We also compared active funds with index funds, finding the gap was slightly wider for the average dollar invested in active funds (negative 1.2% gap per year) than index funds (negative 0.8% gap).
“While index mutual funds had almost no gap, the average dollar invested in index ETFs lagged the buy-and-hold return by more than 1 percentage point a year, a difference worth monitoring.”
In a commentary, Mark LaMonica, Morningstar Australia personal finance director, said the findings highlight a misconception that index-investing per se will closely match benchmark returns.
“Many people assume that investing in passive investment vehicles that track a well-known index means that they are insulated from the behavioural risk that leads to the gap. That is not true. It is how you use these passive vehicles,” LaMonica said.
“Periodically selling one passive ETF and buying another is an active investment decision. Making adjustments to how much is saved and invested in a passive vehicle based on market conditions is making an active decision.”
Overall, Morningstar says the average dollar invested in US managed funds missed out on about 15 per cent of the reported product performance during the 10 years to the end of 2023.
And the report says the relative underperformance of fund investors was due “to the timing and magnitude of their purchases and sales”.
The study says investors in well-diversified “all-in-one allocation” funds experienced the smallest performance gap while the distance widened as strategies narrowed to single-sector bets,
Somewhat counterintuitively, Morningstar did not find a link between fees and investor underperformance relative to fund-level returns.
“You can pick the cheapest of a hard-to-use fund type and still come up well shy of earning its total return by transacting inopportunely,” the report says.