The Bottom Line: Media pieces often imply that buying index funds is a sure route to investment success. However, recent academic research confirms that indexing is not a “magic bullet” that addresses all investor needs. A study of German investors found that individuals investing in ETFs “do not improve their portfolio performance” because of poor market timing combined with poor ETF selection.

The Study: “Abusing ETFs” by Utpal Bhattacharya (Hong Kong University of Science and Technology), Benjamin Loos (University of Mannheim), Steffen Meyer (Leibniz University), and Andreas Hackethal (Goethe University Frankfurt). Published in the Review of Finance in May 2017.

The Process: An international team of researchers studied whether buying ETFs benefits retail investors. They examined the trading data of a “large number” of individual investors at a “large” German brokerage firm for the 2005 to 2010 period to determine whether investment performance improved after the purchase of ETFs. The researchers expected to find that portfolio performance improved after purchasing ETFs.

The research team notes that ETFs account for 84% of index funds in Germany, in contrast to the United States, where the index fund market is split almost evenly between ETFs and open-end mutual funds. Therefore, buyers of ETFs in Germany are more clearly opting for an index approach over an actively-managed approach.

The Findings: Contrary to expectations, the researchers found that portfolio performance did not improve as a result of buying ETFs, even though “ETF users appear to be more skilled investors than the non-users.”

Diving deeper into the numbers, the research team concluded that ETF use did not change trading behavior. Investors who traded more before owning ETFs continued to trade more after owning them. “Investors therefore appear to make the same mistakes when they trade ETFs that they have made in trading non-ETFs.”

The problem: Investors buy ETFs at the “wrong” time and choose ETFs that aren’t lowcost and diversified.

The Implication: “Abusing ETFs” provides further evidence that, in and of itself, index investing does not guarantee that investors will reach their financial goals. The “Research Spotlight” series highlights academic papers that examine the value of active investment management and its role in investor portfolios.

The “Research Spotlight” series highlights academic papers that examine the value of active investment management and its role in investor portfolios.