Over the past decade in the U.S., more than US$2 trillion has flowed into ETFs, while US$0.5 trillion has flowed out of mutual funds, reveal data from Investment Company Institute.

Why? Because of performance and fees.

For example, during the last 17 years, mutual funds on average have outperformed the S&P 500 in only four years, based on U.S. data, says a Richardson GMP report.

Similarly, in Canada during the last one-, three- and five-year periods, the percentage of mutual funds that beat the TSX Composite was 33%, 18% and 25%, respectively.

When it comes to fees, Canadian ETFs have an asset-weighted MER of 0.34%, says the report, versus 0.98% for F-class mutual funds.

“Fees are not the only input in an investment decision, but they are an important one,” says the report.

Disparity on display

Another important factor contributing to the popularity of ETFs over mutual funds is the market’s low disparity in recent years — since 2010.

Index disparity measures how individual stock performance varies relative to the index. Lower disparity means a stock’s performance isn’t often materially higher or lower than that of the aggregate index.

“When disparity is low, even if you can pick the winners, they may not contribute enough to performance to overcome fees and outperform the index,” says the report.

This presents a challenge primarily to actively managed mutual funds. So, with disparity currently being low, investors should favour index investing, suggests the report.

“However, during bear markets and the early years of a bull market, disparity tends to be higher. This may argue for tilting more passively in late bulls but more active when the bear arrives.”

Market efficiency effects

The authors further note that market efficiency matters when it comes to active versus passive investing.

For example, the TSX is less diversified than the S&P 500, so “an active manager could better control the skewed risk that is in the passive index.”

So, in more efficient markets, investors could lean more toward passive indexing strategies to lower costs. And in less efficient markets, they could seek active managers who can take advantage of market inefficiencies or better control risk.

Both win — just not at the same time

Bottom line: think of active versus passive as a continuum.

“Given how far along we are in this market cycle, this may be the time to start reducing passive and tilting a little more active,” says the report.

Further, it’s no longer an ETF versus mutual fund question anyway, says the report, as more and more ETFs are either factor based or actively managed.

Factor-based ETFs can offer a happy medium between active and passive if investors understand the underlying exposures and any added risk of the factor.

Read the full report.