
Exchange-traded funds (ETFs) are simply a way to buy, sell, and hold financial assets conveniently and cost-effectively. They are a tool for investors. Having the right tool for the job helps you to produce a better result, usually with less effort. There are key characteristics to consider when selecting an ETF or mutual fund. ETFs are essentially a power tool for DIY investors.
Like all tools, the outcome still hinges on using the tool well. Similarly, goofing around with it could be harmful. You won’t slice any digits off your hand with an ETF, but you could slice digits off your portfolio returns if you aren’t careful. Analogous to using a power tool, it is easy to have an oopsie if you aren’t paying attention.
Recent data from Morningstar’s 2024 Mind the Gap report highlights this issue. Are investors being naughty with their ETFs? Even more so than mutual fund investors?
The Behavioral Gap
Real-life investment outcomes do not depend solely on buying the right investments. The outcome also depends on buying or selling those investments at the right time. Since you cannot predict the future and markets efficiently price in all currently known information faster than you can act, that means buying whenever you have money to invest and selling when you need money. Unfortunately, humans are wired to interfere with that strategy. We tell ourselves expensive stories stoked by fear or greed that cause us to buy and sell emotionally rather than robotically. The financial media and other narrators are paid to exacerbate that.
The behavioral gap is the difference between the returns an investor would realize buying or selling a given fund robotically (the fund return) and what they actually realize due to buying or selling at different times. Morningstar attempts to measure it each year using 10-year rolling historical periods. The average gap is ~1%/yr, but it is higher with more focused and volatile Sector Funds. Sorting within fund categories also shows that increased volatility worsens the behavioral gap. For example, the most volatile quintile of Sector Funds had a behavioral gap of 4%/yr!
Their 2024 report distinguished between ETFs and mutual funds for the first time. The results are potentially alarming but also informative.
Do ETFs Facilitate Bad Behavior?
One feature that sets ETFs apart from mutual funds is that they can be directly bought or sold directly on an exchange. It is as simple as a few clicks during the trading day and costs under $10/trade. Often, it is free. In contrast, mutual fund orders are executed at the end of the trading day. While they can be bought or sold directly via a broker, they are most commonly sold via a dealer advisor. This makes ETFs very convenient, with a low barrier to buying or selling them. That has democratized investing. However, does that convenience make it easier to misbehave? More frequent buying and selling (trading) is associated with worse outcomes, and it is conceivable that ETFs enable that more than mutual funds.
Open-End Mutual Fund vs ETF Behavioral Gap
Below is the chart from Morningstar’s 2024 Report. Overall, the ETFs had a higher return than the mutual funds (8.0% vs 7.1%). The investors using ETFs also had a higher return of 6.9% vs 6.1%. That is not surprising, given the SPIVA data and the generally lower costs of using ETFs. The gap between the fund return and what investors got in real life was similar at ~1% whether they used mutual funds or ETFs.

Acknowledging that post-hoc sub-group analysis is fraught with data-mining problems, the above chart also contains a few interesting observations. For the broad US equity markets, ETFs had a lower behavioral gap. However, the behavioral gap was much worse using ETFs than mutual funds in every other more narrow category.
The categories where ETF investors were the most naughty relative to mutual fund investors were Sector Equity and Nontraditional Equity. Is that a coincidence? Or are the investors attracted to making these types of narrowed bets also more prone to trading? ETFs make that easier. You can easily buy and sell them, even multiple times in a day. Sure, it is more diversified than trading single stocks. However, that advantage may be marginal if the stocks held by an ETF are strongly correlated. Market timing or sector-picking is still naughty whether you do it with ETFs or stocks.
Can you misbehave using index funds?
Passive index investing helps to remove some of the problems of stock picking. It is common for a handful of stocks to drive market gains while the average stock loses. You cannot predict who those needles in a haystack will be. So, you buy the whole haystack. Operationally, that usually means buying a broad index. It is not completely passive in that decisions about which companies to include in an index are made and the criteria used to select them. However, it is about as passive as we can get for choosing stocks.
Unfortunately, an index can still be used in an active way if we try to time our transactions based on our opinions about the future. For example, buy when we think an index has bottomed or sell when we think it is about to drop. Interestingly, this appeared to happen more often with ETF indexers (1.1% gap) than mutual fund index investors (0.2% gap). Using ETFs makes market-timing trades easy to execute. Unfortunately, predicting the future with enough precision to profit remains elusive, and our natural tendencies translate into underperformance.

Asset Allocation Funds & Investor Behavior
One of the advantages of an all-in-one asset allocation ETF is its simplicity. Simple-to-execute plans are usually easier to stick to. Previous behavioral gap reports, including this one, show that asset allocation funds have the lowest behavioral gap of the various US fund categories. A paltry 0.4%/yr. That may be about as good as it can get (there will always be some lag due to the methodology). Sounds great. However, there is more to the story.

Automating the task of rebalancing helps avoid mistakes compared to managing multiple funds and making decisions each time. That should mean a narrower behavioral gap. However, in the US, much of the asset allocation fund money flow comes from people investing automatically in target date funds through their 401Ks or other employer-sponsored plans. That means automatic contributions with each paycheque. That automation would also be expected to improve behavior by making it the default.
Asset Allocation ETFs vs Asset Allocation Mutual Funds
One of the challenges with ETFs vs mutual funds is setting up automatic purchases. You can set up automatic contributions to a discount brokerage account. However, to buy ETFs, you usually must still log in and make the trade. In contrast, you can fully automate buying a set dollar amount of mutual funds each month or pay period. Frequently, mutual funds are sold via an advisor, adding a layer of behavioral coaching. They may convince you to continue buying or talk you off the ledge from selling when you are fearful. That is one of the main areas where an advisor may add value. So, it is plausible that automation and advisor support may favor mutual funds.
Re-examining the table reveals a significant behavioral gap for asset allocation ETFs (1.6%/yr) compared to their mutual fund counterpart (0.4%/yr). It is possible to “market time” even with an asset allocation ETF. However, I am uncertain if that is what is going on here. Another curious finding is that the total return of the asset allocation ETFs (4.3%/yr) was much lower than that of the mutual funds (6.3%). That is substantial and also unusual, given the usually higher costs of the mutual fund structure. It is the opposite of what I would have expected.
There must be some other important differences between the specific allocation ETF and mutual fund populations studied besides their structure. Further, this is a US data set, and the Canadian-listed asset allocation ETFs are a bit different from their US counterparts. Canada’s asset allocation ETFs are designed to maintain a constant asset allocation to mirror a broad global portfolio, while the US ones are often designed with different objectives (like increasing bonds as you age towards a target date). So, I am not sure how well this applies to Canadians.

Are You Naughty or Nice?
We all have a bit of naughtiness in us. Whether ETFs facilitate bad investor behavior remains a question. Using ETFs helps us to invest in a more diversified way to take compensated risks and minimize uncompensated risks. However, we can still misbehave. At a high level, the overall behavioral gap was similar for ETFs and mutual funds. However, the data highlights some important messages that we can use to improve our investing, whether we use ETFs or mutual funds as the vehicle.
Do not use passive ETFs to actively trade.
Even if you use “passive” instruments, like an index fund, you can undermine some of the advantages by “actively” trading them. That could be trying to time market tops or bottoms (market timing). Or shifting between indexes to “index-pick” where you think the future growth is shifting. Most index-pickers I see aren’t even considering future expected returns. They are performance chasing based on the recent past, and ironically, high current prices suggest lower future returns. The S&P 500 has gotten a lot of that sort of attention recently, but Sector ETFs are the worst for that. While a sector ETF may contain multiple companies, they are exposed to similar market forces. They are also more volatile, which piques your emotions.
Asset allocation funds help, but still require good habits.

Even using an asset allocation ETF does not guarantee that you will behave. I cannot count how many times I have been asked by people whether they should sell their ETFs because of the impending recession that they heard about on the news. Or whether they should buy those funds now vs wait for a pull-back because markets have recently risen. I am not saying those concerns are invalid. I am just saying that what is knowable about those issues has been priced in and that markets will fluctuate unpredictably as the unknowable future unfolds.
Asset allocation funds have the potential to have the lowest behavioral gap. They automate the most complex tasks, like asset allocation details and portfolio rebalancing. That decreases your opportunity to fiddle. However, you must still contribute to them systematically. You can do that if you are disciplined and develop good habits. However, it would be even better if you could fully automate it. Robo-advisors and human advisors can help facilitate that. Unfortunately, they may introduce active management or other costs. So, being honest with yourself about whether you are going to be naughty or nice and choosing the model that works for you is important. Before you find yourself on Santa’s lap.
ETFs are a great tool for making investing simple and effective, but they should be used correctly. Do not turn a good investment into a bad one through naughty behavior.
“being honest with yourself about whether you are going to be naughty or nice and choosing the model that works for you is important”, wise guidance, Dr. Soth! I commonly discuss this with friends and family members. Great article!
Thanks! I think that ETFs make for an elegant investing solution. However, we must still be able to integrate them with our human tendencies.
Mark
Really love your site! Very relevant info for me as a physician individual investor in Canada. I found this article spot on. I have done well since switching from a full service mutual fund service to personal investing in ETF’s. But I have definitely been tempted to “tinker” and adjust my portfolio much more over time based upon perceived (over?)valuations, especially in S&P500.
Currently I like using Fidelity’s line of all-in-one ETFs. They are a bit higher MER ~0.4% and use a mix of factor based ETFs rather than cap-weighted. This way I feel I am diversified away from the US megacaps.
They include a small allocation to bitcoin, which I also like, as a way to get a bit of exposure there. So far, performance has been good and outpacing the Blackrock/Vanguard/Horizon equivalents.
If you have not done recently, I would be interested to see an article comparing the various all-in-one Canadian options. I wish Horizon had stayed with the corporate class structure for their all-in-ones as that was a useful distinguishing benefit for me. I also read your article about their upcoming large phantom distribution and glad I sold HBAL in corp when they switched models.
Thanks again,
Jeff
Hey Jeff,
I have branched out a bit too in an attempt to fulfil my need to tinker (in a gradual and an evidence-informed way). I’ve been rebalancing out of my QQQ and into AVUV, DFSV, and DUHP for a couple of years now. And some Canada since things look so bleak here (I had us at market weight <5% for years). The Fidelity line sounds interesting. There are so many flavors out there. With factor investing, in particular, the methodology and implementation are super-important. That will be another series of posts. I have experts to help me with it, but have been snowed under a little.
The valuation issue has been coming up for years actually and keeps going higher. It is a concern, but there are so many variables at play that it isn't really actionable. Other than to plan for the likelihood of lower returns for a period of time when making financial plans. That's my take.
Funny you should ask about an all-in-one review. I just updated my comparison of all-in-one ETF page that is in my DIY investor hub. It includes estimates of fee/tax drag for the restructured GlobalX/Horizon offering. I’ve also started a couple of other posts about evaluating ETFs and hopefully my “top picks” more broadly. Of course, it is going to be my typical really deep dive so is taking me a while!
Mark