The collective performance of active mutual strategies has been abundantly called into question over the past two decades. Back in 1997, Mark Carhart’s seminal study1 found that, on average, active funds lag the market after fees and transaction costs, and that there is no evidence for persistence in performance after controlling for exposures to the market, size, value and momentum factors.
Many subsequent studies confirmed these findings, making the case for broad index-based strategies. The adoption of such strategies has been facilitated by the introduction of ETFs, which usually aim to replicate an index at low costs. Over the years, investment flows into ETFs have grown sharply, which raises the question whether traditional active funds could become obsolete.
But without supporting evidence, it is premature to jump to this conclusion. While the performance of mutual funds has been extensively investigated by academics, the empirical performance of ETFs remains largely uncharted. To address this issue, Robeco’s David Blitz and Milan Vidojevic recently took a closer look at the performance of a broad sample of US equity ETFs2.
They analyzed the performance of these ETFs following the same approach that has been commonly used to evaluate the performance of actively managed mutual funds. They found that ETFs fell short of expectations by collectively lagging the market. So, while the idea of tracking a market index at very low costs with ETFs may be attractive on paper, in practice things prove more complicated.
Other reasons for concern include the fact that many ETFs are not that cheap in the first place. Moreover, ETFs are frequently used as tactical trading instruments, designed to bet not only on the market, but also on all kinds of sectors, themes or investment styles, instead of a means to gain broad market exposure for the long term.
In their study, the authors also analyzed the performance of ETFs targeting well-known factors such as value, momentum, quality and low-risk factors. These factor ETFs were sorted following two different methods: first depending on their name and then using regressions of the excess returns of an ETF on the different factors.
In all cases, the ETFs’ performance proved underwhelming
In all cases, the ETFs’ performance proved underwhelming. While some factor categories achieved a higher raw return than for the market, on a risk-adjusted basis there is little evidence supporting any added value. Sharpe ratios appeared to be below or similar to the market, and CAPM alphas were either negative or close to zero.
The two researchers also created groups of anti-factor ETFs, selecting funds with negative exposures to the academic factors. They determined six groups of ETFs, such as large, growth or aggressive investment. Among these, only the growth and aggressive investment ETFs managed to beat the market, but they did so with higher volatility levels, resulting in lower Sharpe ratios.
Altogether, these results show that ETFs, be they factor-based or not, have yet to prove that they can beat the market over prolonged periods of time, or generate better performance than actively managed mutual funds. Investors looking for an attractive, low-cost alternative to conventional mutual funds should therefore definitely tread carefully.
1 Carhart, M. M., 1997, ‘On persistence in mutual fund performance’, The Journal of Finance.
2 Blitz, D. C., Vidojevic, M., 2019, ‘The performance of Exchange-traded funds’, working paper.
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