Is there proof that ETFs produce better returns than most mutual funds?

The impressive and deserved success of ETFs is based in large part on the idea that they’re better than mutual funds.

A reader recently asked for some validation of the claims made for exchange-traded funds. “I often hear that ETFs produce better returns than most mutual funds,” he wrote. “Do you have any charts/graphs that prove this point?”

Frankly, I think mutual funds are too disrespected these days. They’re widely available, simple to invest in and accessible to people with as little as $100 to $500, depending on the company. But a lot of mutual funds deliver returns that are mediocre or weak when compared with their benchmark stock and bond indexes. With ETFs, you get the returns of these indexes, minus ultralow fees.

There are data to back up the ETF performance advantage – the SPIVA report cards issued by S&P Dow Jones Indices. The latest report, from midyear, found consistent mutual-fund underperformance in the Canadian equity category compared with the S&P/TSX Composite Index. Just more than 93 per cent of Canadian equity funds fell short of the index over the previous 12 months, 91 per cent underperformed in the previous three years, almost 90 per cent underperformed in the previous five years and almost 89 per cent underperformed over the previous 10 years.

Comparable levels of underperformance were seen in U.S., international and global equity funds. The one category where mutual funds fared well was Canadian Dividend and Income Equity. Only 32.5 per cent underperformed their benchmark index in the previous 12 months, 49 per cent underperformed over the past three years and just over 60 per cent underperformed in the previous five years.

There are lots of different kinds of ETFs these days – traditional funds that track indexes, funds that apply a screening process to the stocks in an index and funds that are run by a portfolio manager who chooses securities. This is called active management, and it’s the way most mutual funds are run.

The fees on index-tracking ETFs are low enough to be almost inconsequential to your long-term investing success. You can buy an ETF tracking the S&P/TSX with a management expense ratio of 0.06 per cent. Popular Canadian equity funds may have MERs in the 2-per-cent range.

There are plenty of smart people running mutual funds. But with those higher fees, it’s a struggle for them to deliver consistent returns that beat ETFs. That’s why ETFs produce better returns than most mutual funds.