Performance Comparison of European Exchange Traded Funds (ETF) and Index Mutual Funds

Table of content

II. List of abbreviation

1. Introduction

2. Differences between ETFs and Index Mutual Funds

3. Methodology

4. Result
4.1. Results for Hypothesis
4.2. Results for Hypothesis

5. Conclusion

III. References

II. List of abbreviation

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1. Introduction

The first paper of our course in Risk Management dealt with the risk of European Exchange Traded Funds (ETFs). Despite of the risks that ETFs have, they provided also a high chance of making profits. Hence, this paper deals with the question if the performance of ETFs is better than the performance of quite similar index mutual funds. This question is very important for retail investors and fund managers, because the structures of these two products are not that different. Both offer the chance for investors to hold a well-diversified portfolio but at very low costs. Of course, a lot of researchers did yet different investigations about the difference between ETFs and index mutual funds returns. A few papers are shortly presented and will give an overview about the pros and cons of ETFs and index funds.

Aber et.al. (2009) compares the price volatility and tracking error of ETFs and indexes from two different providers. The researchers take four iShares ETFs, which track an index like S&P 500 and compare them with Vanguard mutual funds, which also track the same indexes. The goal of this paper is to check which of the two assets type has the lower price volatility and tracks the underlying index better. The timeframe for this research is from 2000 until 2006. One outcome of this work is that the daily returns of ETFs and index funds are highly positively correlated. Therefore, the volatility doesn’t differ much between the two assets. The result for the tracking error is not that clear. In half of the cases ETFs (index funds) track the underlying index better than half of the index funds (ETFs). Due to the fact that the sample is too small with only four funds of both types, one cannot know if this result would be the same in other cases.^[1]

Another interesting paper is the one written by Kostovetsky (2003). In this paper the author wants to find out different purposes for retail investors for investing into an ETF or an index mutual fund. He argues that the main difference between these two assets is the management or transaction fees that are charged. These points are also explained in my previous seminar paper about risk of European ETFs. Furthermore, the author argues that index funds are more suitable for smaller investors than ETFs are. This fact is also based on the creation-redemption process which is later explained in this seminar paper.^[2]

The paper of Rompotis (2009) deals with the trading performance of specific iShares ETFs between 2005 and 2006. The whole paper is based on trading data which includes 250 daily trading days of 73 different ETFs. The author wants to find out whether these ETFs carefully track their index or not. If they don’t do it exactly it offers the possibility of arbitrage to large investors. The result was that most of the ETFs had a different market price in comparison to their actual net asset value (NAV). Another result was also that the higher the volatility of an ETF was the higher was the probability of a mismatch between the market price and NAV. In a lot of cases, investors had to pay more for the ETF in comparison to its true value.^[3]

Generally there are not a lot papers that deal with the performance of ETFs and index funds for a long time period. Most authors argue that ETFs are quite new in financial markets. Hence, the number of ETFs is still very small in comparison with other products (as one will see also in chapter 2). I took the paper of Sharifzadeh et.al. (2012) because it was the only one that I found which compares the performance of ETFs with quite similar index funds for an 8 year time period. Additionally, the authors try to proof the statistical significance for their results.

Basically, this seminar paper starts with a short overview about the main difference between ETFs and index funds. The next chapter presents the methodology which was used by Sharifzadeh et.al. (2012). The main part of this seminar paper is based on their work. In my opinion it provides statistical significant results about the different performances of ETFs and index funds. Section 4 deals with the results of the research of Sharifzadeh et.al. (2012). It is divided into the results of the two different hypotheses they made. At the end one will find a short conclusion about this seminar paper.

2. Differences between ETFs and Index Mutual Funds

Generally, ETFs have a comparable structure like common Mutual Index Fund. However, some features of ETFs are very special and give some advantages to its investors. One big difference which has to be highlighted is the different trading possibilities. Index Mutual Funds can only be bought directly at a fund providing company or financial advisers. Orders are accepted during the whole trading day of stock markets, but transactions are only done at the end of a trading day, when the new price of the fund is published. The price that an investor has to pay is calculated with the Net Asset Value (NAV). On the other side, ETFs can be traded during the whole day (as the name Exchange Traded Fund suggests). The price that has to be paid does not have to be exactly the same like the NAV. It can be slightly different to the actual market value, which offers arbitrage possibilities, especially for institutional investors.^[4]

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^[1] Aber et.al. (2009)

^[2] Kostovetsky (2003)

^[3] Rompotis (2009)

^[4] Etterer (2004)