5 Reasons Why Funds Tracking Same Equity Style or Theme Can Perform Differently

Investors may not realize going in, but Exchange Traded Funds (ETFs) and mutual funds nominally tracking the same equity investment style or theme can perform very differently. This performance divergence can occur due to several factors:

1. Management Style

Active vs. Passive Management: While most ETFs are passively managed to track an index, many mutual funds are actively managed. Active management in mutual funds can lead to performance differences as fund managers make decisions that may deviate from the underlying index.

2. Fees and Expenses

Cost Differences: ETFs typically have lower expense ratios than mutual funds. Over time, these cost differences can compound, leading to performance disparities even when the underlying assets are similar. Expense ratios are among the most important factors affecting a fund’s performance and the returns generated. Because expense ratios diminish the principal of an investment, this cost is a key factor in ETF indexing performance. For example, two funds tracking the same index can end up with significantly different returns if one is more expensive than the other.

3. Trading Mechanics

Pricing and Liquidity: ETFs trade throughout the day at market prices, while mutual funds are priced once daily at their net asset value (NAV). This difference in trading mechanics can result in short-term performance variations, especially during volatile market conditions.

4. Portfolio Composition

Tracking Error: Even passive funds may not perfectly replicate their target index due to factors such as sampling techniques or cash holdings for liquidity purposes. This can lead to slight performance differences between funds tracking the same index.

5. Tax Efficiency

• Capital Gains Distributions: Due to their creation/redemption mechanism, ETFs are generally more tax-efficient than mutual funds. Mutual funds may be required to sell securities to meet redemptions, potentially triggering capital gains distributions that can impact after-tax returns.
• Fund Size and Cash Inflows/Outflows: The size of a fund and the timing of its cash flows can significantly affect its performance. Larger funds may encounter difficulties in sticking to their strategies, as significant inflows or outflows can hinder their ability to deploy or raise capital effectively.

Studies have also shown that thematic ETF investors experience return gaps of up to 500 to 600 basis points (bps) compared to mutual funds due to poorly timed trades. Much of the discrepancy in investor returns can be linked to ineffective market timing by fund investors. Results may be especially poor in more volatile funds, as investors trade those more frequently and may tend to buy high and sell low. While funds usually report total returns, investor returns can provide a clearer measure because they account for the effects of cash inflows and outflows from investors.

In conclusion, while mutual funds and ETFs often follow the same theme or strategy, various factors can lead to differences in performance. Investors need to carefully weigh these elements when choosing between comparable funds and consider the timing of their investments to match their financial objectives and risk tolerance.

David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning. He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.