Does Trading by ETF and Mutual Fund Investors Hurt Performance? Evidence from Time- and Dollar-Weighted Returns

Vol.17, No. 3, 2019

Ananth Madhavan and Aleksander Sobczyk
This paper contributes to the growing literature on the divergence between the return the average fund investor experiences and reported buy-and-hold returns. This is a topic of considerable importance to investment advisors, plan sponsors, and policy makers seeking to encourage investors to save more for retirement. Our sample constitutes all US-domiciled open-end mutual funds (active and index) and exchange-traded funds (ETFs), and covers 6,766 fixed income and equity funds with assets in excess of $13 trillion. We demonstrate directly that return chasing behavior-based on the time-series sensitivity of flows to past returns-explains the cross-sectional pattern of return gaps across funds. Indeed, we find empirically that ETFs where flows are positively correlated to past returns (return chasing) exhibit a greater return gap between what the average investor experiences and what is reported. We show that liquidity- and flow-related characteristics explain the cross-sectional variation in return gaps for funds. Smaller and more narrowly focused funds have the most negative gaps.

Some commentators have noted that the ability to trade ETFs intraday can lead to high turnover and sub-par performance for investors. We find little empirical support for this notion. The return gaps across ETFs are small on average, −0.93% for equity funds and −0.52% for fixed income funds. This finding is very relevant for administrators of defined contribution plans who must decide what funds are offered to participants, and who are often reluctant to offer ETFs despite their low cost. The results also indicate several areas where public policy makers or advisors can meaningfully enhance investor education. For example, advisors may want to complement standard buy-and-hold returns with flow-weighted returns, as part of their ongoing investor education efforts. Our evidence on the cross-section of return gaps suggests that educational efforts be focused on the trading of narrower, more niche products.