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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{ 7 comments… read them below or add one }

Mary October 15, 2010 at 1:48 PM

I am having fun with this discussion and I hope you are enjoying it also. No Mr. Bogle is not the end all, I have read numerous studies, books and reports. If you have read Mr. Bogle’s books he does indeed back up his position, but his position is not to “beat the market.”

However leaving him aside I agree that expenses are not the end all but neither is performance. RISK is the biggest factor here. The investor has to be rewarded for the risk.

I have become firmly convinced by research and 30 years of investing experience that for retirement planning and the other needs of the retail investor performance chasing as well as yield chasing are losing propositions. I find it far better to define the goals and allocate accordingly and then to rebalance those allocations as the market dictates (which is not buy and hold). I am not an indexer, I utilize index funds and individual stock and bond issues. I never use managed funds. ( If you go through the trouble of picking a managed fund you might as well just pick your own stocks.)

When advising those less inclined to financial research my mantra is:

Work builds wealth, saving stores wealth, investing protects wealth.

I think that should be the goal of 95% of the investors – to protect their wealth against the ravages of inflation.

Admittedly there are the 5% who are inclined and able to delve further into the markets and try to seek the top performers which I would term “momentum investing.” Even though I am inclined I have never had success with momentum investing. Momentum investing requires a knack for timing trends which is my investment knowledge shortcoming.

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Neal October 15, 2010 at 5:05 PM

Mary….yes this is a pleasant conversation.

I actually agree w/most everything you’ve said. I actually do use momentum investing and it’s something I’m very comfortable with and happy with too.

Anyway, for people without a method and without the ability to stick to it, I agree that they should not get started with this.

Anyway, thanks for the civil dialog.

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Mary October 15, 2010 at 12:09 PM

Hi, you imply that mutual funds are “actively managed” and ETF’s are not, not so. There exists both active and passive etf’s and active and passive mutual funds. There are expensive open end mutual funds and there are inexpensive ones, ditto for etf’s. In the case of Vanguard ETF’s, the market leader in ETF’s, the etf is just a share class of the mutual fund.
The only difference is in trading platform which it is true does have distinct characteristics. Some of those characteristics are positive and some are negative.

Positive: slightly lower expense ratios (especially when considering Vanguard’s new cost structure), picking price point of entry, being able to own in some 401K’s which do not offer similar funds.

Negatives: causes some people to trade far too much, brokerage commissions to trade, brokerage commissions to add to your position, brokerage commissions to diminish your position. Discounts and premiums are currently fairly small but could increase, not a true negative, just an added layer of knowledge that the investor has to be aware of. Being able to short your position – not a good idea for 95% of the retail investors.

My biggest disagreement comes in your performance analysis. Mr. Bogle, Mr. Bernstein and others have been much more eloquent on the subject of passive investing than I ever will be and I again refer you to their writings. But let me just say that chasing performance is a loser’s game. One should choose an appropriate asset allocation and invest appropriately and reallocate when appropriate.

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neal October 15, 2010 at 12:39 PM

I’ll just respond to your last points.

Mr. Bogle is not the be-all and end-all in the investment world. He has an opinion and others have other opinions. I don’t ever see him backup his opinion with facts.

At the end of the day, lower expense is only ONE element of performance — and performance is the name of the game.

Many strategies have consistently beaten the “buy and hold”. Not every single year…but consistently.

The jury is out. I don’t think it’s really possible to say this or that strategy is always best no matter what.

It depends on your appetite for risk and reward. That’s my opinion and experience but I certainly respect your well-made arguments.

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Mary October 15, 2010 at 11:33 AM

Oh, I am sorry, this article is so wrong on so many levels. The index mutual fund has existed for years and in some cases the ETF is simply a share class of the open end mutual fund. The difference between open and closed end funds, which is what we are talking about, is that the closed end fund – the ETF – has a fixed number of shares that are traded on the exchanges. There are index ETFS, there are index mutual funds, there are actively managed ETFs, there are actively managed mutual funds.

Indexing is a whole other topic. I refer you to numerous books and articles by John Bogle, for one, to review the benefits of indexing and passive investing.

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Neal@Wealth Pilgrim October 15, 2010 at 11:38 AM

Mary, what specifically do you take issue with? I don’t see any contradiction between the post and your comment.

What have I missed?

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Andrew @ Money Crashers October 9, 2010 at 9:10 PM

I’m on the side of ETF’s only because there is so much against actively managed funds and how they never seem to outperform. The only caveat is if you can find a manager that has consistently outperformed, in good times and bad, I think there is something to be said for his or her ability to beat the market. Ultimately I think there’s room in your portfolio for both passive and active investing.

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