ETFs vs. Mutual Funds – A New (Unexpected) Wrinkle

by Neal Frankle, CFP ®

ETFs versus mutual funds. It’s a conflict as old as the Hatfields and the McCoys…well maybe not that long. But certainly, this argument has been floating around ever since ETFs were created.

etfs vs mutual funds

Since that time, ETFs have eaten mutual funds’ lunch. Does that mean you should invest in ETFs now? Let’s take a look under the hood and see.

ETFs are quasi-index funds that are extremely inexpensive. An index fund just buys the stocks that are held in an index and doesn’t do much trading. That’s what keeps the costs low (and, as you’ll see in a moment, that’s what has created this new problem). The main difference between an index fund and an ETF (exchange traded fund) is that the ETF trades like a stock. You can buy an ETF during the day and know what price you’ll pay for it– unlike a mutual fund. You can sell it short and you can use limit orders to protect your investments. Oh…and one more thing…ETFs are typically even cheaper to own than index funds.

Mutual funds have active managers and trade more often. That drives costs up and can trigger capital gains taxes. Why would anyone want to buy a mutual fund (more cost, more tax) over an ETF? Think about someone who wants to make the best investments for retirement. Shouldn’t she just stick entirely to ETFs?

Not if you care about her…and here’s why: Performance. This is another part of the new problem.

Some experts suggest that the performance of the biggest ETFs is going to suffer. More and more people are shoveling their money towards the largest ETFs for the reasons stated above. Even now, 25% of all the money in the stock market is invested in these ETFs. That means more and more money is being invested in fewer and fewer places. It’s more concentrated. And as money gets more concentrated, the investments are subject to greater volatility.

Keep in mind that if you (and everyone else) buy the ETF that owns all 500 stocks that are part of the S&P 500, you are ignoring the other 8,000 companies that are available. (There are other drawbacks to using ETFs, but I’ve already discussed them.) So what these experts are suggesting is that the success of the ETF is the very thing that will hurt it going forward.

This is an interesting argument and something to consider if you are an investor. Long-term investors theoretically don’t care about volatility, but in reality everyone cares. However, even if you think you can stand added volatility, concentrating your capital in a small segment of the market is probably not your intention. Yet that’s what you’re ending up with when you buy ETFs.

You could buy smaller, more esoteric ETFs to increase diversification. But you have to consider that smaller funds have less liquidity and possibly higher spreads between the buy and sell prices. If that’s the case, you’re right back where you started. High volatility (and possibly higher costs because of this price spread).

The solution?

Well…if you aren’t a buy-and-hold person, this is a nonissue. If you buy funds based on performance, your system will tell you what to do.

For example, one investment strategy I’ve written about before evaluates mutual funds and compares them to ETFs. It then ranks funds and ETFs by performance and buys the strongest of the lot. If (as people argue) ETFs perform better because their expenses are lower, you’d expect the ETFs to hold all the top spots. Right?

Well…they don’t. Sometimes they are in the top, but often they are not. That’s because while most funds don’t outperform the indexes, some do. The most important determinant of your investment success is your investment strategy — not low cost.

If you have a system that only buys top-performing funds and then rebalances your portfolio periodically, you’ll buy ETFs when they are doing well and you’ll ignore them when they aren’t.

Performance is reported net of all fees. This argument of only buying the cheapest funds can be very expensive. By doing so, you might give up a dollar to save a nickel.

Given the direction that investors’ dollars are flowing, it makes even more sense to consider performance, cost and volatility rather than just cost.

How do you side on the “mutual funds vs. ETFs argument? Are you going a completely different direction and looking into a guaranteed equity bond fund?

 

photo credit by zokuga, Flikr

 

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