It has become common knowledge that the average actively managed fund underperforms its benchmark after cost. It has also become common knowledge, that ETFs and index funds are a low-cost alternative that improves performance for the average investor because it avoids the underperformance of the average active fund.
Now, imagine you get a mail in which the authors of a study claim that:
“We conclude that, from a pure performance perspective, the allure of ETFs finds little support in the data.”
Of course, I had to read that study. The study was written by David Blitz and Milan Vidojevic from Robeco, a company that is known for high-quality quantitative research. They looked at all the ETFs listed in the United States between 2004 and 2017 that covered the US stock market, parts of (e.g. sector or factor ETF and leveraged and inverse ETF). They found that only 40% of stock ETF outperformed the broad US stock market, which I find a high number already. After all, an ETF is supposed to track an index minus fees. I would expect 0% of ETF to beat their benchmarks after costs.
But what seemed particularly odd about their results was the alpha they calculated for ETFs in their sample (which I should note is free of survivorship bias because they include active and defunct ETFs). The chart below shows the alpha of the ETFs in their sample based on a simple CAPM model and on a 6-factor model. I compare this in the chart as the authors do indirectly in their paper with the results of a paper by Fama and French from 2010 that looked at all actively managed US mutual funds from 1984 to 2006.
Net of fees, the alpha of ETFs is -0.75% per year, while the alpha of active funds is -1.13%. If corrected for factors like value, size, momentum, etc. this performance gap narrows even more. The true 6-factor alpha of ETFs is -0.8% per year and for active funds -1.0% per year. And one might even argue that since active fund fees have declined more rapidly than ETF fees, this gap may have narrowed even further in recent years.
Alpha of active funds and ETFs
Source: Blitz and Vidojevic (2020), Fama and French (2010).
What is going on here?
It turns out that if you look at only those ETFs that track the whole market, the performance gap to actively managed funds is still large. It is only the sector and factor ETFs that create the significantly lower alpha of ETFs in their sample. Unfortunately, I don’t know what the average alpha is for actively managed broad market mutual funds in the United States, so we cannot compare apples to apples.
But the Robeco research provides an important insight into another trend. While I disagree with their conclusion quoted above, I agree that if you invest in the wrong ETF, your performance is likely to be significantly below the market average.
Historically, ETFs were almost exclusively launched on broad stock market indices like the S&P 500. It was only after the financial crisis when the ETF industry exploded that the number of sectors and thematic ETFs increased rapidly. And as always, a company will only launch a narrow sector or thematic ETF if it sees sufficient client demand. Hence, these narrower ETFs are launched in fashionable areas that are glamorous. Just think of the 3D printing hype a few years ago and the ETFs that were launched on that theme. But because the general public is generally not very savvy about the future performance of themes and sectors, these narrow ETF pretty soon start to underperform the broad market by a wide margin. And investors who have these ETFs in their portfolios start to lose out.
Hence, what the ETF industry has done with its increasing product shelf of narrow ETF is to shift the asset allocation decision from fund managers to investors. Today, the investor decides which sector exposure she gets in her portfolio. And with that, the alpha of the average ETF investor started to decline rapidly. As the chart shows the negative alpha seems to increase at an accelerating speed. Yes, ETF investors have consistent performance tracking an index, but it seems they are consistently wrong in choosing the index.
Cumulative CAPM Alpha of all ETF
Source: Blitz and Vidojevic (2020).