Exchange traded funds (ETFs) track indexes for better or worse, but as of late, mutual funds have mostly been beating the indexes. Most mutual funds notoriously underperform their benchmarks, but with this shift, we might be sharpening our knives for a plate of crow. Or are we?
According to Lipper Inc., 95% of intermediate bond funds beat the Barclays Capital U.S. Aggregate Bond Index and 68% of diversified U.S. stock funds beat the Standard & Poor’s 500-stock index in 2009, reports Jason Zweig for The Wall Street Journal. Year-to-date, 58%of stock and bond funds are beating their underlying benchmarks. [Making the Switch from Mutual Funds to ETFs.]
However, Zweig explains how indexes don’t always reflect what fund managers are doing. For instance, the Barclays Aggregate’s market average gained 6% in 2009, whereas most taxable investment-grade bond funds were up 14%. The reason for the discrepancy was because the index consists of bonds issued by the U.S. Treasury and government-related equities while corporate bonds make up only 18% of total benchmark.
The average intermediate-term bond fund holds half its assets in government bonds, almost 40% in corporates and 10% in foreign debt. The reason why funds deviate from their indexes with riskier holdings is because funds charge expenses, and a fund with a 1% annual cost has to beat the index by at least 1% to justify fees.
Furthermore, the United States has issued around $2 trillion in new debt to bail out the financial system, which has pushed up the percentage of Treasuries to more than 29% of the index, compared to 22% at year-end 2007.
In the stocks arena, managers mostly favored small companies over larger ones. Small stocks tanked during the market crash but recuperated much more quickly than their larger counterparts. The apparent cunning of many managers may be mostly due to the flip side of their earlier inadequacies. [ETFs vs. Index Funds: Which Is Right For You?]
Habitual underperformance in mutual funds is a reason we’re big fans of ETFs. Millions of investors, however, are going to be keeping close watch on actively managed funds to see if they can generate alpha. While active ETFs are a marked improvement over the mutual fund model – after all, you get lower fees, transparency and intraday liquidity – they’ll have to add value by beating their benchmarks, as well. [4 Reasons to Like Actively Managed ETFs.]
For more information on mutual funds, visit our mutual funds category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.