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

by Neal Frankle, CFP ®

 

etfs vs mutual funds

In it’s most simple terms, ETFs are very inexpensive mutual funds.  They have exploded in popularity – especially commission free Exchange Traded Funds. Does that mean you should invest in ETFs and forget about mutual funds?  Not so fast.

What Is An ETF?

ETFs are quasi-index funds and as I said they are extremely inexpensive. An index fund just buys the stocks that are held in an index and doesn’t do much trading. That’s one reason why the costs are so low. They are almost identical to index funds.  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 before you buy it– unlike a mutual fund or index 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 less expensive than index funds.   Oh…and one more, one more thing.  Because the ETF managers trade so infrequently, investors have less potential exposure to capital gains tax.

With so much going for ETFs, why would anyone want to buy a mutual fund? There is really only one reason…..Performance.

ETF Performance Issues

There are a few concerns I have about ETF performance.  First, some experts suggest that the performance of the biggest ETFs is going to suffer because as more and more people shovel their money towards the largest ETFs it concentrates investment dollars in fewer and fewer places. 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 ignore the other 8,000 companies that are available. So the success of the ETF is the very thing that may hurt them going forward.

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).

And this isn’t the only performance concern.  An index fund or ETF will often mimic the performance of it’s underlying broad market index.   That’s great if the market is headed up.  But if the market drops 30% your ETF might do the same thing.  Sometimes it’s nice to have a defensive investment strategy too and most ETFs don’t provide that.

Also, while indexes often beat most actively managed funds, they don’t beat all of them.  As a result, by excluding mutual funds from your universe of potential investments you unnecessarily limit your options.  There is no good reason to do this.

 The solution?

If you are a buy and hold investor, ETFs can be a good option.  I’m the first one to admit it.  But if you buy funds based on performance, your selection method 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. Bottom line?  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 actually be very expensive because it completely ignores funds that might be doing far better. By doing so, you might give up a dollar to save a nickel.  Yuk.

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?

 

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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