Put ETFs and mutual funds on the test track

BOSTON (MarketWatch) � I was surprised this week to read that exchange-traded funds are �still popular despite not making money.�

Mostly, I was stunned by how the article, at InstitutionalInvestor.com, twisted numbers and logic to come up with that headline.

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Last time I checked, no investment is popular when it doesn�t make money. That said, there are reasons to buy investments during times when they are flat and down, and that�s where the Institutional Investor story � and a lot of average investors � got it wrong. They seem to think the real investment decision is �mutual funds or ETFs� rather than �domestic or international; large-cap or small.�

Cut from the same cloth

Exchange-traded funds typically are built like a passive index fund but trade like a stock. They typically have cost and tax advantages compared to traditional mutual funds, although trading like a stock � with the requisite transaction costs � sometimes makes them less effective than funds for savers who make regular, small-dollar deposits.

But ETFs are still mutual funds. It�s like a car manufacturer using one chassis to make two similar-but-different cars. This will become increasingly true with the advent of actively managed ETFs, effectively making them like a traditional mutual fund but on the ETF platform.

Ultimately, quality of the management, index construction, cost structure and the way a fund is used by the investor determines superiority when funds and ETFs are compared.

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The Institutional Investor story noted the booming growth in ETFs, despite the fact that only one-third of U.S.�listed equity issues generated a positive return last year.

�Of course, that performance largely reflects the market itself,� the article said. �The Standard & Poor�s 500 SPX �slipped 0.04% � In a year when few assets returned much of anything, one shouldn�t expect the typical passively managed ETF to do any better.�

But those numbers don�t jive with the market, and don�t prove the point that ETFs are better than funds.

For starters, while a �positive return� is always a goal, beating the Standard & Poor�s 500 isn�t always the target; many ETFs track indexes completely unrelated to the S&P, more broad or narrow. Likewise, traditional funds can benchmark to other indicies.

An ETF tracking the MSCI World Index has a different agenda than one tracking the S&P 500, for example.

Moreover, the S&P 500 was off 0.004% last year � less than the article stated � only if you excluded dividends. The index gained 2.1% including dividends. The MSCI World Index, by comparison, lost 5.5%.

By Morningstar�s accounting, just 23.5% of traditional funds beat the S&P 500 last year, compared to 29% of ETFs. Include the dividends in the index�s returns and just 13% of traditional funds had bigger gains, compared to almost 20% of ETFs.

Measured against the MSCI World Index, however, 56% of traditional funds beat the benchmark in 2011, compared to just 49% of ETFs.

Before you get too carried away with statistics from bygone time periods showing that funds can�t keep pace with the market, consider these same comparisons from 2009 and 2010. Nearly 72% of funds � and almost 70% of ETFs � topped the 26.5% total return of the S&P in 2009; in 2010, 56% of funds and 61% of ETFs surpassed the S&P�s total return of 15%. The MSCI World Index, by the way, beat the S&P in 2009 and lost to it in 2010.

Allocation matters

The point � aside from showing that fund statistics can be used to draw seemingly any conclusion � is that your portfolio is about the assets in the funds or ETFs, rather than which vehicle type you use. The underlying investments and how you mix them together using funds determines if a portfolio meets expectations, whether the hope is to beat the market or to provide blended, steady, consistent returns.

ETFs and mutual funds should be popular in any market conditions, because they remain the best way for the average investor to get diversification and either professional management or index construction at a reasonable price, and people should be investing in all market conditions. But you won�t find money flowing into, say, domestic stock funds when the public is panicky about the future of the market, and money will rush out of emerging markets if international conditions make them nervous.

That�s not a statement on whether to buy funds or ETFs � it�s a reaction to holdings and market conditions.

Ultimately, the fund-or-ETF decision should be made from the bottom up. Decide the asset class you want to be in, and the preferred investment strategy � passive or active � that fits with your overall goal. Make that happen and your choice should be popular with your family, no matter whether it�s a fund or an ETF.