Jack Bogle, the pioneer of index funds, famously expressed concern about the rise of exchange-traded funds (ETFs) during his tenure as CEO of Vanguard in the 1990s. His main apprehension was that ETFs, by their very design, would tempt investors to trade frequently, undermining the long-term gains of the market. Bogle’s hesitation to offer indexed ETFs has been validated, as a new Morningstar report titled “Mind the Gap 2024” reveals.
The report examines the performance gap between standard fund returns and dollar-weighted returns—essentially measuring how well investors who actively traded funds performed compared to those who simply bought and held. While index mutual funds showed a modest performance gap of 0.2 percentage points per year over the 10-year period analyzed, the gap was significantly wider for index ETFs. On average, investors in ETFs earned 1.1 percentage points less per year than the fund's regular returns.
This 0.9 percentage point per year difference between mutual funds and ETFs may seem minor, but it represents a greater loss than what many investors pay for actively managed stock funds. This disparity effectively erodes one of the key advantages of index investing—lower costs and consistent returns over time.
According to Jeffrey Ptak, Morningstar’s chief ratings officer, there are several factors that contribute to this gap. One key factor is the differing environments in which mutual funds and ETFs are commonly used. Mutual funds are frequently found within retirement plans like 401(k)s, where participants often follow an automated, "set it and forget it" approach. This system leads to more disciplined, regular investments and fewer emotional or impulsive trades. ETFs, on the other hand, are typically held outside of retirement accounts, where investors are more likely to make ad hoc decisions.
The structure of these plans encourages mutual fund investors to be less hands-on, which can lead to better outcomes. “It can be helpful for investors to save and invest in a more routinized, mechanized way that minimizes ad hoc, discretionary decisions,” says Ptak. In contrast, ETFs are often traded more actively, leading to poorer timing and lower returns.
Another significant factor is the nature of the funds themselves. While both ETFs and mutual funds offer broad-based index options like total stock market or S&P 500 funds, the ETF space is also populated by a wide range of narrowly focused, specialized index funds, often sector-specific. These specialized ETFs tend to be more volatile, and investors are often not equipped to navigate that volatility successfully. They tend to buy when prices are high during bull markets and panic-sell when prices drop, locking in losses.
“Volatility tends to short-circuit investors,” Ptak explains. “The sheer amplitudes of performance up and down are very difficult to process in ways that help investors capture their funds’ total returns.” In the study, sector-specific stock funds exhibited some of the widest gaps in returns between mutual funds and ETFs, with mutual fund investors losing an average of 1.9 percentage points annually to poor timing decisions. However, the gap was even larger for ETFs, where investors lost 3.1 percentage points per year.
A potential third reason for the ETF/mutual fund gap lies in the typical clientele. While mutual fund investors are largely made up of retirement plan participants, a significant portion of ETF assets—around two-thirds—are controlled by financial advisors, according to Cerulli Associates. Advisors, in theory, should know that excessive trading can hurt returns. Yet, the desire to demonstrate activity and justify their fees may lead some to trade more frequently than is prudent.
Ptak acknowledges the possibility of advisors contributing to the underperformance seen in ETF returns, particularly in sector-specific funds. “It does suggest that [advisors] might be focused on a good story, which resonates with their clients but is difficult for them to use successfully,” he says.
This raises an important question about the role of the advisor in managing client expectations and behavior. James Martielli, Vanguard’s head of investment and trading services, points to Bogle’s timeless advice: “Don’t just do something, stand there.” This guidance reflects the wisdom of staying the course, particularly in the face of market volatility.
For wealth advisors, this sentiment is especially relevant. “For advisors, their real value—and we’ve written about it for decades—is understanding your clients’ goals and being the emotional coach to help them not make those poor investment decisions when emotions run high,” says Martielli. The role of the advisor isn’t just about picking the right investments, but also about guiding clients through the ups and downs of the market, helping them avoid the temptation to make short-term, emotion-driven decisions that can erode long-term returns.
In the context of this report, the implications for RIAs and wealth managers are clear. ETFs are a powerful tool, but like any tool, they must be used wisely. The evidence suggests that investors, including some advisors, may be misusing ETFs by trading too frequently, especially in volatile sectors. This erodes the performance gains that index investing is designed to deliver.
The key takeaway for wealth advisors is the importance of maintaining a long-term perspective, particularly when managing client portfolios with ETFs. By focusing on the long-term goals of their clients and resisting the urge to overtrade, advisors can help close the performance gap and deliver better outcomes for their clients. In doing so, they not only preserve the advantages of low-cost indexing but also reinforce the core value proposition of financial advice: helping clients stay disciplined and focused on the future, rather than reacting to the day-to-day noise of the markets.
