More Than Fees

Not too long ago, I wanted to buy a stable municipal bond fund. My purpose was to glean a dividend while I parked my cash awaiting better opportunities. To research this, I looked at the share price of several possibilities to assess which showed the least volatility. I didn’t want downward fluctuation because I didn’t want to lose principal when I sold the fund.

The difference in stability of equivalent exchange-traded funds (ETF) compared to index funds was dramatic. The former showed considerably more up and down movement than the latter. It seemed a plain vanilla index fund was better for my purpose. It occurred to me that more traders must buy the ETF, which would explain its greater fluctuation, short-term buying and selling. Of course, this was just a hypothesis, not a proven fact.

Now, James Chong and his colleagues at California State University in Northridge, Calif. have added clarity to my casual observation, at least for stock funds — though the principals are directionally the same for bond funds as well. Their article, “S&P 500 ETFs and index funds: Are fees all there is to it?” was published in the Journal of Wealth Management, Fall, 2011; volume 14, #2, pages 59-67.

The authors of the study found that investors take into consideration more than expenses when they choose between equivalent ETFs and index funds. They also consider personal goals. If the investor is buying a fund for short-term exposure to the market for trading, he tends to select an ETF. On the other hand, if he wants to “buy and hold” and thereby fill a niche in his portfolio requirement, he likely will select an index fund.

Chong and his associates used both the standard Capital Asset Pricing Model and the dual-beta model to compare ETFs (three letters) to analogous mutual funds (five letters) versus a standardized benchmark, SPX (see table below). The study included data from 10 years (February 5, 2001 to February 4, 2011).

The dual-beta model estimates factors independently for an up market versus a down one. This is important because investors’ responses to a down market are different than the reverse. They trade more. Volatility increases. This phenomenon is called, “Volatility Asymmetry.” It means there is less stability in a down market, which is, I believe, an important concept of the paper.

By using the dual-beta model, specific fund characteristics were revealed that were invisible to analysis using only the CAPM. This included the major finding of the study that IVV is appropriate for short-term trading and FUSEX is better for long-term tracking.

It was puzzling to me that the authors focused only on IVV and FUSEX.

In our study, IVV and FUSEX dominated [outperformed] SPY and VFINX so we focused on them. In head-to-head comparisons, IVV demonstrated greater statistical alpha than SPY, while having lower beta than SPY whether looking at CAPM, up-market, or down-market,” Chong wrote in an email. “FUSEX and VFINX behave similarly as investments, but as of our analysis, FUSEX had substantially lower fees.”

Though the research addressed only specific exchange-traded and index funds, its conclusion may have wider application. It scientifically shows us what we do and to some degree why we do it.