Performance of Mutual Funds and Exchange Traded Funds (ETFs)

Table of Contents

Abstract 2

Introduction 3

Literature Review 6

Data and Methodology 12

Findings and Discussions 15

Fund Performance 16

Expense Ratio 18

Dividend Taxes 21

Fund Listing and Fund Performance 27

Conclusion 28

Reference List 31

Abstract

In this paper, I investigate the performance of mutual funds and exchange traded funds (ETFs) listed in Europe for the period March 2008 until March 2018. The empirical result found in this research indicates that the median of the 12-month return difference between the benchmark index and the mutual funds and ETFs in my sample is 34 basis point. Thus, most mutual funds and ETFs underperform the benchmark index tracked. I also examine the relationship between fund expense ratio and fund performance and find that fund expense ratio is significant in explaining the fund return. However, the expense ratio has an extremely low explanatory power on the fund performance. Furthermore, I investigate the impact of dividend taxation on fund returns. Similar to expense ratio, dividend taxation is one of the contributor towards the fund underperformance. However, dividend taxation yield an even lower explanatory power than expense ratio. Lastly, I examine the effect of fund listing on the performance of funds. It is observed that when fund listings are jointly taken into account with expense ratio and dividend taxation, the explanatory power for fund listings is extremely minimal.

1. Introduction

Exchange traded fund (ETF) is an investment product which has grown tremendously since its first creation in the United States (US). According to Poterba and Shoven (2002, p1), even though the ETF is first created in the year 1993, it has been growing exponentially throughout the years, especially in the year 2000. By 2001, the ETF has gestated to an astounding amount of $79 billion in assets held, which made up 2.4 percent of the total assets in equity mutual fund. Even after its initial introductory phase, the ETFs continue to grow at an astonishing pace. According to the EY Global ETF Research 2017 Report, ETF which totaled to $417 billion in 2005, has expanded to $4.4 trillion by September 2017 with an impressive growth rate of 21% per annum. With the persistent annual growth, ETFs will yield increasing assets under management and would be a vital substitute for investors interested in mutual fund investments.

ETFs are of interest for investors mainly because the funds give investors the ability to buy and sell the investment vehicle throughout the day, which is very similar to trading a common stock on the stock exchange. This gives the investors flexibility in their investments. This feature is also the main principal that distinguishes ETFs from traditional mutual funds. Furthermore, another benefit of the ETF is that it gives the ability for investors to get an exposure to a specific, narrowed sector or market in an “inexpensive and efficient method” as stated by Gallagher and Segara (2005, p.53). Gallagher and Segara (2005) also suggests that ETFs are more tax efficient due to limited realized capital gains allowed. Moreover, ETF can also be traded in smaller quantity as compared to futures contracts and hence yield advantages over the mentioned derivative product. As a result, the ETF has grown immensely popular among investors.

Therefore, in this paper, I examine the performance of the Exchange Traded Fund (ETF) that are listed in the stock exchanges in the European market. The main objective of this research is to compare the performance of ETFs and other passive funds listed in the Europe market with regards to their tracked benchmark index using data that covers the period from March 2008 until March 2018. According to PWC’s 2^nd Annual Global ETFs survey (2015), American ETFs is expected to have a cumulative annual growth rate of 23%, the European ETF market is expecting a 27% annual growth while the Asia market is expected to have 18% compounded annual growth over the next five years. Despite the evidence showing a robust growth of ETFs in European market, there are relatively less researches done to investigate the Europe ETFs in comparison to the literatures done on the US ETFs. Hence, this paper adds value by providing recent researches on the European ETF. The key question that this paper intends to answer is how are the performances of these ETFs in the Europe market?  How are the performance of the ETFs and other traditional mutual funds listed the Europe market in comparison to the performance of the tracked benchmark index? What are the causes for the ETFs to yield such return?

This essay is organized as follows. First, I document the total return for the mutual funds and ETFs in my sample and compare them against the tracked benchmark index. I observe that the funds listed in Europe yield returns ranging from an outperformance of 3 basis points to an underperformance of 54 basis points. The underperformance of the fund is slightly larger than the underperformance of funds listed in the US market with an amount of 28 basis point as found by Elton et al (2000). Elton et al (2004) later identified that the fund performance has a negative relationship with the fund’s expense ratio which is also similar to the results that I have found in my study. I also observe from my result that the fund underperforms the benchmark index by a slightly larger amount than the reported fund expense ratios. Hence, this indicate that fund underperformance cannot be attributed solely to expense ratios.

Besides that, I also note that there are variations in the performance of the funds that tracked different geographical indexes. As an example, mutual funds provided by Vanguard that tracked S&P500, MSCI Europe and MSCI Japan has different fund returns across the different region even though the fund expense ratios are within a similar range. Therefore, this indicates that there are evidences where the fund expenses are unable to explain the funds’ underperformance.

Third, I observe the impact of dividend taxation in explaining the variation of the fund underperformance in my sample. In the results that I have found, the explanatory power of dividend taxation is extremely low. I find that the R square for dividend taxation is only 0.5 basis point, which is one quarter of the explanatory power of fund expense ratios. Hence, this suggests that although the funds listed in Europe are subjected to different dividend taxation based on the different benchmark index’s regions, it cannot be attributed entirely in explaining the fund returns.

Fourth, I examine the impact of fund listings on fund returns. I identify that when fund listings are jointly taken into account alongside fund expense ratio and dividend taxation, the explanatory power of fund listings disappear entirely.

My paper contributes to the research of ETFs by providing recent insights towards the relationship of fund performance listed in the Europe market with respect to expense ratios, dividend taxation and fund listings. There are not many researches on the ETF universe that involve recent data. Most researches such as the ones from Elton et al (2004), Mussavian and Hirsch (2002), Gallagher and Segara (2005), Poterba and Shoven (2002) used data prior to 2008. Thus, my research intends to fill in this gap by providing more up to date study regarding ETFs.

In Section 2 I describe the Literature Review and in Section 3 I outline the process of extracting the data required for this study and the methodology used in analyzing the data. In Section 4, I discuss the empirical results that I have found and in Section 5 I summarize the conclusion of this paper.

2. The Literature Review

Exchange Traded Fund (ETF) definitely has been a continuously unfolding issue in the academic literature. Since the first ETF has been created in 1993 in the United States (US), ETFs have been growing exponentially, up to 19.8 billion dollars by the end of 1999. Elton et al (2000) is the first literature to discuss ETFs after its creation. Referring to Elton et al (2000)’s literature, in 1998, Spider, an ETF that track the S&P500 has achieved the highest daily dollar volume for any share traded. This indicates the vast importance of ETFs. Meanwhile, the first ETF issued in Europe was in April 2000 which has been discussed by Mussavian and Hirsch (2002) in their literature. Both Elton et al (2000) and Mussavian and Hirsch (2002) noted that the ETF in the US and Europe are transparent, and that deviations of the price of ETFs from their Net Asset Value (NAV) are minute. This is due to the ability of the creation and deletion of ETFs. Gallagher and Segara (2006) concur with Elton et al (2000) as they found consistent results that indicates the ETFs instruments in Australia does not have a large variation between the ETFs price and NAV.

Hence, following the creation of ETF in the US and the issuance of ETF in Europe, other countries in the world have also issued ETFs to replicate indexes. However, despite the vast growth of ETF, Gallagher and Segara (2005), on the other hand, noted that ETFs in the Australian market are not as heavily adopted in comparison to the US and Europe market. Gallagher and Segara (2005) identified that the reason for investors to not embrace the Australian ETFs is due to the up-front fee that is required in order to enter the funds in Australia are absent in most funds in the US. Therefore, this creates a disadvantage towards fund managers in Australia to initiate the issuance of ETFs.

One area of study that is significant in observing the behavior of ETF is the study of the performance of ETF. In general, the average performance of the ETFs could be identified from Svetina and Wahal (2008) literature. This is due to the large samples of ETFs used and the inclusivity of the ETFs across different sectors and markets. The samples of ETFs used amount to 584 ETFs that include a wide range of sectors such as domestic equity, international equity, and fixed income ETFs. The literature shows that the ETFs underperform the benchmark index on average. Another finding that Syetina and Wahal (2008) generate from their study is that 83% of the ETFs focused on a specific and narrow market in order to give investors niche exposures and hence cannot be directly investable using index mutual funds. There are also studies that intend to investigate whether using trading strategies are effective in trying to gain excess return in investing in ETF. Tse (2015) examines the utilization of momentum trading strategies using the ETFs. However, the results found that the momentum trading strategies are statistically insignificant to the return on ETFs. Only few ETFs exhibit excess return, especially during the 2008 financial crisis. However, the return plummeted immediately post financial crisis. Overall, the momentum strategies using ETFs yield worse return than the simple buy and hold investment strategies. The limitation of this is that it does not include the results momentum strategies might exhibit in relation to other investment strategies using ETFs such as value strategy and other trading strategy.

There are also comparisons of studies found in the performance of ETFs across different countries and the reason for the ETF to yield such return. In the US, Elton et al (2000) noted in his result that Spider underperform the S&P500 Index and the main causes of the underperformance are the management fees and dividend reinvestment that results in loss of return. Similarly, as Blitz et al (2012) concluded in their result, the European ETFs also underperform their benchmark index. However, Blitz et al (2012) has found that the underperformance is not only due to the expense ratio, but it is also explained by dividend withholding taxes. Milonas and Rompotis (2014) narrow their research further to focus on the ETFs traded in the Swiss market. One of the most surprising findings that they find is that the tracking error that the ETF exhibit is substantially large. This is the same case as the global emerging markets ETF. The global emerging markets which include countries such as Russia, China, South Korea, India, South Africa and Brazil, according to Blitz and Huij (2012), the returns of ETFs in comparison to the returns of the benchmark index do not yield any significant meaning as the ETFs manifest high levels of tracking error. The situation is different in markets where the ETFs are in the initial growth phase. Prasanna (2012) show that the ETFs listed on Indian Stock Market has a staggering growth of 37% annually from 2006 until the year 2011. Unlike the researches done on ETFs in developed markets and the emerging markets discussed before, the Indian ETFS outperform the benchmark index, CNX NIFTY, by 3% per annum. Besides that, Gold ETFs yields excess return over the market by 13% after the financial crisis period. Moving on to South Africa, Strydom et al (2015) has identified that the South African ETFs have tracked the benchmark index more closely than the index funds. Hence, the author concludes that investors searching for exposure to the South African market could invest in ETFs rather than the mutual index fund for better replication of the index benchmark. However, the performance of ETFs is similar to the developed market ETFs, where the ETFs underperform the benchmark index, which is FTSE/JSE Top 40 Index in this case.

Apart from that, there are also studies that aims to identify the benefits of ETF. One of the advantage of ETF is that it is tax efficient. Poterba and Shoven (2002, p.8-9) conduct a study to show the pre-tax and post-tax returns on SPDR in comparison with the pre-tax and post-tax return on Vanguard Index 500. The authors find that pre-tax and post-tax return for SPDR and Vanguard Index 500 are very similar, albeit the return for the ETF is slightly lower than the mutual fund. This is due to the “tax efficiency” characteristic of the ETF. The main feature of ETF that leads to lower tax on the return is; “the ETF distribute securities with a basis below the market price to eliminate the potential capital gains tax liability ETF investors might face if these shares were sold”. However, the limitation of this paper is that it only uses SPDR that tracks the S&P 500 index in the paper’s analysis. The other ETFs have expense ratios which are significantly higher, which translate to lower return.

Besides that, another advantage of ETF is that it provides a specific exposure to a certain market desired by the investors. This is clearly shown in the literature produced by Meric et al (2010) where the author used ETFs in order to determine the sector that experience the largest losses during the financial crisis. Meric et al (2010) provided an insight into the performance of the ETFs in bear market which is from the year 2007 until the year 2009. The authors conclude from the results that they have generated using the Sharpe and Treynor ratios that the highest losses are generated by ETFs from the financials and the home construction sector whereas the sectors that yield the least losses and therefore, the best performances are the ETFs from the healthcare and consumer staples sector. Hence, the feature of ETF that targets a narrow, niche market is also useful not only for investors but also for academic researches.

Moving on to another area of study, there are also various researches in determining the difference between ETFs and other traditional index mutual fund. In Kostoversky (2003)’s paper, the author show that the main difference between index mutual fund and ETFs are management fees, shareholder transaction fees and taxation efficiency. The author also concludes that there are a few qualitative difference between the two investment instruments. One advantage of ETF is that it is relatively simple to trade ETF as it can be bought or sold throughout the day, yielding a similar characteristic to common stock. Apart from that, the investors also have the ability to place stop-loss and limit orders on the ETFs which are vital in restricting the amount of loss an investor could incur. On the other hand, the advantage of index funds is that it is relatively easier than ETFs for investor to accomplish the entire process of investment. Index fund requires less procedures for an investment to be executed. The limitation of this paper, as stated by the author is that the models proposed are not a perfect representation of real-world scenarios.

Another literature, Agapova (2010) compares the index fund and ETFs and finds that the two investment instruments are substitutes for each other, albeit not perfect substitutes. On the contrary to Kostoversky’s (2003) paper, the evidence in Agapova (2010) paper’s result indicate that the different features of the index funds and ETFs are subjected to more than just price and cost. The coexistence of the funds naturally target different market segments resulting in the funds being focused on different market niches.

Apart from that, there are also a research in another area that study the difference between the performance of ETFs and closed-end country funds. Harper et al (2005) overall finding is that ETFs yield higher return than closed end funds due to the lower expense ratios. Furthermore, ETFs have higher Sharpe ratio than the closed end funds. Besides that, closed end funds exhibit negative alpha, which indicates that investing in a passively managed investment using ETF yield higher return than actively managed investment using closed end funds.

Taking into account all the literature reviewed above, it is noticeable that there are less researches on European ETFs despite the European market being the second largest market where ETFs are heavily and frequently traded. Furthermore, there are less researches that use recent data and hence this is the gap that I intend to fill. The finance research that I am planning to conduct is to examine the performance of the index mutual funds and ETFs that are listed in Europe by using up-to-date data. Although it is also observable that there are not many ETFs research in Asia market and it is interesting to conduct one due to its high growth and the potential for the ETFs to outperform the market, there are limitations in terms of data availability from Asian countries. Apart from that, the largest ETFs being traded are mainly in the US, followed by Europe, Asia Pacific and the rest of the world. Hence, the vast availability of data for Europe market will make this research possible. One of the incentive for conducting this research is also to investigate whether the results found by Blitz et al (2012) regarding the performance of the ETFs still holds true in the current financial market.

3. Data and Methodology

I focus my analysis on the traditional index funds and ETFs which are listed in Europe. According to EY Global ETF Survey 2017, ETF is predicted to gain asset growth of 15% per annum in the next five years. Besides that, EY believes that ETFs asset could grow to $7.6 trillion by the year 2020. In Europe, ETF has been growing up to 20.4 percent on average per annum as reported by Deloitte in the Growth of ETFs in Europe report. The European ETF’s asset under management has an average growth of 20.1 percent per annum for the past decade.

I specifically narrow the analysis of my study to index funds and ETFs that track the main market indexes which give exposures to investors towards diversified equity markets. The market indexes include S&P500 and MSCI USA for US related exposures, MSCI Europe for Europe exposure, MSCI Japan for Japan exposure, MSCI World and MSCI Emerging Markets for exposures to the respective regions. The primary source of fund-level data for this research are Thomson Financial Datastream and the Morningstar website. Besides that, there are also index related data that are gained from the MSCI website and the individual traditional index funds’ websites.

This study is first started with the creation of a comprehensive list consisted of all available traditional index fund and ETFs. The lists of index funds and ETFs are collected from Thomson Financial Datastream. The list is constructed to focus on the European market. Therefore, the list includes funds listed in the stock exchanges from Austria, Belgium, Bulgaria, Channel Islands, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Kazakhstan, Latvia, Lithuania, Luxembourg, Netherlands, Norway, Poland, Portugal, Russia, Serbia, Slovakia, Slovenia, Spain, Sweden, Switzerland, Turkey, Ukraine and the United Kingdom. In order to gather the traditional index funds, I filter the list to include only funds that consist of the word “index” and “idx”. Then, the list is further restricted to only include funds that are not enhanced indexing funds, institutional funds and insurance funds. Due to a large amount of data amounting up to more than 5,000 funds, only a sample of the whole list is taken into consideration. This is due to the limited availability of duration given for conducting the research and limited manpower to analyze the fund-level data on a case by case basis. Hence, only index funds that are issued from established providers are taken. The providers are Vanguard, State Street Global Advisors (SSgA), Pictet and HSBC. Next, I gather funds that only focus on tracking the major benchmark indexes such as S&P 500, MSCI USA, MSCI Europe, MSCI Japan, MSCI World and MSCI Emerging Market. The funds are then checked on an individual basis using the Morningstar website, the Financial Times and the website of the companies that issue these funds in order to find the fund’s objective and investment policy. This is to investigate the nature of the fund and the clients that the funds attract. Any enhanced funds and institutional funds are excluded from this list.

Meanwhile, the details for ETFs are also collected from Thomson Financial Datastream. The list are filtered to include only European listed ETFs. Similar to the index funds data, only a sample of the whole list is taken into the paper’s analysis as the total data amount to 7,000 ETFs. The sample is taken by choosing ETFs from main ETF providers such as iShares, Lyxor and Street Tracks. The funds are then check on a case by case basis by using the Morningstar website, and the Financial Times in order to filter for funds that track only the major benchmark indexes. Apart from that, due to the characteristic of ETFs that are created with the purpose of gaining exposure to a specific industry or region, I exclude any ETFs that are too narrowly focused on a certain sector of the market indexes.

I obtain the data for the return of the funds in my sample by searching Thomson Financial Datastream for the Price of the funds and the benchmark index tracked. The gross total return for the funds are then calculated. The total return data are assembled from the period of March 2008 until March 2018 for a period of 10 years. The median for the 12 month return of the funds are then compared to the respective benchmark index’s return and the difference are then calculated. The expense ratio data for the traditional mutual funds are collected by searching the Total Expense Ratio data in Thomson Financial Datastream and the expense ratios for ETFs are obtained from the Morningstar Website by checking them on a case by case basis.

As mentioned above, the funds in my sample are selected from leading fund providers. The providers for the traditional mutual funds include Vanguard, State Street Global Advisors (SSgA), Pictet and HSBC. Meanwhile, the ETFs are from iShares and Lyxor. There are also funds that have multiple listings in the European stock market in which I have included in my sample. In total, a sample of 85 funds consisting of the most relevant traditional mutual funds and ETFs is created for this research. Since this paper aims to investigate the performance of funds listed in Europe for the most recent period, this paper only include the period from March 2008 to March 2018. The data for the previous period is already covered in Blitz et al (2012) research in which the authors investigate the performance of European fund for the period January 2003 to December 2008.

4. Findings & Discussion

In this empirical results section, I examine the explanatory power of fund expense ratios and dividend withholding taxes on the performance of funds listed in the European market.

4.1 Fund Performance

Table 1

Performances

This table exhibit the fund performance in my sample. The fund performance is reported from my measure of 12-month return difference between the funds and the benchmark index tracked. The data covered the period from March 2008 until March 2018.

In this section, first of all, I summarize the performance of the funds in my sample in the table above. I began by investigating the performance of ETFs and index mutual funds with respective to the performance of the tracked benchmark indexes. Table 1 summarizes the median of the 12-month return difference between the ETFs and mutual index funds against the tracked benchmark index. According to Table 1, almost all funds underperformed the benchmark indexes. Only mutual funds provided by PICTET have excess return over the tracked benchmark indexes. PICTET funds that tracked S&P500, MSCI Japan and MSCI Emerging Markets (EM) outperform the equity indexes by 3 basis points, 0.2 basis points and 2 basis points respectively, which is not significantly large. For the rest of the funds, the extent of the fund underperformance ranges from 2 basis points to 54 basis points per year, which is slightly different from the underperformance found in Blitz et al (2012) paper. In the paper, Blitz et al (2012) identified the underperformance of the European index funds and ETFs to be in between 50 basis point and 150 basis point per annum. Moreover, the median for the underperformance of the funds in my sample is 34 basis point. This value is much lower than the median identified by Blitz et al (2012) in their research where the underperformance of the funds listed in Europe has a median of 84 basis point. This indicates that the funds’ performance might have improved for the period 2008 to 2018 as compared to the funds listed in Europe for the year 2003 to 2008 as identified in Blitz et al (2012) study. However, the underperformance of European ETFs and index funds in my study are larger in comparison to the US oldest ETF, The Standard and Poor’s Depositary Receipts (Spider) that tracked the S&P 500 index, where the funds underperform the benchmark index by only 28 basis point as mentioned in Elton et al (2000)’s literature.

As provided in Table 1, all the funds do not outperform the benchmark indexes by a significantly large amount. It is identified that the best performing funds are mutual funds issued by PICTET which track the S&P 500 with an outperformance of 3 basis point. In my sample, only mutual funds provided by PICTET outperform the tracked benchmark index. Meanwhile, the worst performing funds are mutual funds provided by HSBC and ETFs from iShares that track the S&P500 and MSCI USA with an underperformance of 47 basis point and 54 basis point respectively. In general, I conclude that these results suggest that most mutual funds and ETFs in my sample yield returns that are lower than the tracked benchmark index.

I also note that there are return differences between funds that track different benchmark indexes. As shown in Table 1, the median for the underperformance of funds tracking S&P 500 and MSCI USA is 44 basis points, whereas the funds tracking MSCI Europe, MSCI Japan and MSCI EM have medians of 32, 35 and 32 basis points respectively. In contrast to the findings from Blitz et al (2012), the lowest median underperformance of funds in my sample is from funds that tracked MSCI EM, with a median of only 20 basis points, and not from funds that track the Japan benchmark indexes as found in the authors’ research. However, the fund tracking the MSCI EM has a high tracking error and thus the median does not yield any significant meaning. In conclusion, there is a different range of fund performances which varies across the benchmark indexes that the funds tracked.

4.2 Expense Ratio

In this section I examine the extent in which the underperformance of European ETFs and mutual funds are caused by the fund’s total expense ratio. The total expense ratio is a specific fee charged to the investors of the funds. The expense ratio is consisted of the purchase fee, redemption fee, auditing fee and other related expenses. I summarized the reported fund expense ratios for my fund sample in Table 2 below.

Table 2

Expense Ratios

This table exhibit the expense ratios as reported by the funds in my sample.