From my point of view transaction costs are the major reason for the underperformance, since these costs are treated totally differently by these two fund types. While traditional funds have to buy and sell stocks on the market when investors buy or sell shares of the fund, ETFs don’t face any of these transactions. All transactions for the creation and redemption of shares are done by a so-called authorized participant. While the traditional index fund has to pay the transaction costs out of the assets of the fund, impacting the performance, the transactions for the ETF shares are paid by the investors via the bid/offer spread and do not impact the fund’s performance.
Even though traditional index funds do not underperform ETFs in all markets, ETFs seems to be the better solution with regard to their performance, especially for mid- and long-term investors. That said, it is remarkable that some ETFs are positioned at the bottom of their respective tables, leading to the conclusion that investors have to do proper due diligence before buying an ETF.
In addition, one needs to bear in mind that the study looked just at performance, and no assumptions were made with regard to the quality of the index replication, i.e., ratios such as correlation, tracking error, and tracking difference were not taken into account for any of the evaluations.
This study showed that expenses should not be used as the only criterion for selecting funds, since that might lead to products that are cheap for management fees but very expensive for the underperformance they might generate in the investor’s portfolio.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.