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Svetina compares the performance of exchange traded funds (ETFs) with retail mutual funds. He investigated whether or not ETFs can compete with mutual funds on a performance basis.

He opined that ETFs hoping to compete favorably with mutual funds need to explore untraded sectors of the market and, in short, develop uniqueness in their designs. Since ETFs are derivative securities that pattern themselves after specific underlying indexes, the author explained that they should underperform the indexes because of transaction costs. 

The writer emphasized that on average the ETFs underperform their benchmark indices and are not immune to tracking errors. He compared the returns of ETFs and mutual funds and found that when they follow identical indexes their returns are statistically indistinguishable. 

When competing ETFs to incumbent ETFs emerge, the decline in demand affects the incumbent ETFs more heavily than existing mutual funds tracking the same assets. He believes that flows going to competing ETFs are flows that would have gone to similar mutual funds without the competition. He also finds that the creating and exiting transactions for incumbent ETFs are felt not only by them but also by the incumbent mutual funds tracking the same indexes. 

Because ETFs trade throughout the day, they have the advantage over mutual funds of immediacy in that the net asset values of mutual funds are calculated after the market closings. 

He concluded that his data suggested that ETFs offered immediacy of intraday trading, without sacrificing performance, and in some cases improved returns over competing mutual funds. Therefore, the overall takeaway from this article appears to be that ETFs which target special indexes and exist without undue competition from similar ETF “brothers” can offer immediacy of trading, with the opportunity to outperform a competing mutual fund.

Source: Svetina, M. (2010). Exchange Traded Funds: Performance and Competition. Journal of Applied Finance, 20(2), 130-145.

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