Publications

- May 1, 2019: Vol. 6, Number 5

Mutual funds versus ETFs: The pros and cons

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ETFs have been grabbing a lot of press recently. But are they a better option than mutual funds? Dana D’Auria, managing director and portfolio manager at Symmetry Partners, weighs in on the topic.

Some investors consider mutual funds passé in the era of ETFs. You disagree with that assessment. Why?

Mutual funds and ETFs are just different vehicles for achieving an investment purpose. There are pros and cons for both, and sometimes the benefits become disadvantages depending upon the user. For example, ETFs are touted as a vehicle that can be traded at any time during the day, whereas open-end mutual funds only trade once a day. But evidence suggests the more we trade, the more we hurt our returns, on average. For most investors, jumping in and out of positions based on intra-day news is only going to inflict self-harm. ETFs also externalize costs, while open-end funds internalize them. ETF investors pay every time they trade, while mutual fund investors get in and out at net asset value. So, ironically, if you trade often, an open-end fund may be more advantageous for you because the costs you create by trading are effectively shared.

What advantages do mutual funds offer?

Probably the biggest advantage is the ability to gain access to a broadly diversified portfolio of capital assets at any investment level. Mutual funds offer access to thousands of holdings across multiple countries, sectors and industries with very low minimums. They also provide economies of scale for the many costs associated with running any investment: manager fees, trading costs, administration, regulatory, etc. Mutual funds also give investors easy access to whatever strategy they may want to pursue, with a broad array of manager options.

What about the higher fees associated with mutual funds, which effectively cut into returns?

There is no doubt that fees matter. Academic studies suggest cost is one of the most important drivers of return, meaning that higher cost often does not lead to better performance. But we have to be precise when we talk about where these costs are coming from. For example, the generally low expense ratios of ETFs largely have to do with the fact that ETFs tend to be passive index trackers. Mutual funds, on average, cost more because active management — wherein you are paying more for someone to pick stocks or time the market for you — is still principally in the province of open-end funds. For most of the major asset classes, you can purchase a passive index-tracking mutual fund at the same low cost as an ETF.

Is transparency an issue in your mind, when you take into consideration that mutual funds’ holdings are only known to investors at certain points in time?

Mutual funds tend to release their holdings on a lag. This is due in part to regulatory requirements to make it harder for traders to take advantage of a fund’s shareholders by trading in front of them and driving up the price — or vice versa on sales. I doubt most investors would benefit much by seeing holdings on a quicker basis, though. Fund fact sheets, which give you a summarized breakdown of the types of exposures that all of those fund holdings add up to, are a useful channel for transparency. I can see on a fact sheet that my bond holdings total up to a particular overall credit rating and duration, which gives me a clear-eyed view of the major risks I am taking in the portfolio. If you are invested in a fund where you feel the need to monitor intra-month — whether the manager is off the reservation buying the wrong kinds of stocks or bonds — you should consider another investment.

For which kinds of investors do mutual funds make sense?

Mutual funds are a great vehicle for the average investor who wants to get a well-
diversified portfolio at a fair price and not pay a whole lot of attention to how they are trading. Trading directly in securities requires a large sum to get to a high level of diversification and you pay trading costs every time you move in and out of a position. The latter also goes for ETFs. The basket of ETF securities may also be worth more or less than the market price at which you transact. I would venture to guess few retail investors are considering whether they are buying in at a premium or selling at a discount. Then, of course, you want to pay some attention to whether you are trading during a market dislocation, wherein prices may simply not reflect value at all. Mutual funds don’t require expertise to trade. The reality for most investors is that they may be best served by a vehicle that protects their particular purchases and sales from the market’s vagaries.

 

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