Mutual funds have long been a staple for investors, offering instant diversification and the prospect of having a professional money manager in charge of your portfolio. But changes to the structure of investment vehicles, specifically the introduction of exchanged-traded funds (ETFs), have rendered the old-school mutual fund obsolete.
The unfortunate reality, however, is that most of the retail investment community has not caught on. According to the Investment Company Institute, an estimated 100 million Americans owned mutual funds in mid-2017. That amounts to some $18.7 trillion in total assets that is owned via a suboptimal legal structure. The result is an industry that, according to David Swensen, Yale’s legendary investment guru, “costs investors billions in lost returns every year – while coining money for itself, its employees, and its distributors.”
In this article we’re going to walk you through why mutual funds should, and eventually will, go the way of the dodo bird. We’ll also show you why ETFs – the ideal replacement for mutual funds – provide an advantage in nearly every way that mutual funds fail. To get started, we first need to understand exactly what a mutual fund is.
What’s a Mutual Fund?
In the simplest terms, a mutual fund is an investment vehicle that pools money from investors for the purpose of investing in securities such as stocks or bonds. Most mutual funds are operated by professional money managers, who attempt to allocate funds in the most productive way possible. All mutual funds have a stated investment objective, and the management teams must act in a way so as to facilitate this objective.
The primary benefit of mutual funds lies in the fact that they offer instant exposure to a wide array of securities. Rather than building out a portfolio with numerous positions, investors can simply buy shares of a mutual fund, which represent a shared interest in the fund’s underlying holdings.
While this is indeed a great benefit, it can now be achieved through a different type of investment vehicle known as an exchange-traded fund, or ETF. Not only do ETFs provide all of the benefits of mutual funds, they contain almost none of the drawbacks, which can be substantial, as you’ll see shortly.
Active vs. Passive Management
One of the big draws about mutual funds is the notion that you’ll have a “professional money manager” in charge of selecting securities. While that sounds great at face value, a deeper look at the data shows that in the vast majority of cases, you actually don’t want a money manager in charge of the portfolio. Huh?
Every professional money manager is tasked with beating a particular benchmark or index. This is how they demonstrate their effectiveness as a portfolio manager. If they can’t beat the index they’re up against, then they’ve added no value to the portfolio whatsoever. So, what percentage of professional money managers beat their respective benchmarks? Let’s find out.
The S&P Dow Jones Indices, a division of S&P Global, produces a scorecard each year that shows how well managers do with respect to their benchmarks. It’s called SPIVA – the S&P Indices Versus Active scorecard. Here are a few interesting facts.
- Over the last 5 years, 76.5% of large-cap professional money managers have underperformed the S&P 500
- Over the last 5 years, 81.7% of mid-cap professional money managers have underperformed the S&P MidCap 400
- Over the last 5 years, 92.9% of small-cap professional money managers have underperformed the S&P SmallCap 600
Rather striking, right? And if you think this type of subpar performance only occurs with regard to stocks, think again. Over the last 5 years, 98% of investment-grade long fixed-income managers have underperformed their respective benchmarks. For the high-yield bond segment that figure is 94.3%, and for emerging market debt it’s 94.9%.
To make matters worse, the longer time frame we look at, the worse these performance figures get. Over the last 15 years, 92.4% of large-cap managers, 95.1% of mid-cap managers, and 97.7% of small-cap managers failed to outperform their benchmarks on a relative basis. That’s downright awful …
Imagine how many people would go to Vegas and play blackjack if the odds of losing were 92% on each hand … probably not many, right? Yet millions of investors still, as we speak, have their money under the control of these so called “professionals.” Based on their historical performance data, it would be more apt to call them unprofessional money managers.
So the moral of the story is, NEVER opt for actively managed mutual funds. They have an enormously high probability of underperforming the market, and as we’ll see in the next section, they charge you an arm and a leg for this privilege. The better bet is simply to use an ETF that provides passive exposure to the benchmark itself.
One of the worst aspects about mutual funds are the fees that they charge. Not only are the average expense ratios for mutual funds significantly higher than for ETFs, mutual funds include an array of not-so-transparent costs that can quickly add up. Let’s go over a few of these now.
Most actively managed mutual funds are sold with a load. This is an upfront cost that is paid to the broker for their effort in selling you a specific fund. Loads for mutual funds generally range from 1-2%, which is substantial, especially when you consider the poor performance we just discussed.
In contrast, an ETF can provide you with identical exposure to the benchmark you’re looking to get exposure to, and there are no loads. In today’s day and age, with the plethora of investment products available to investors, there is absolutely no excuse to pay a load, ever. If you speak to a financial advisor who says otherwise, that advisor is acting in their own best interested and should be scolded.
In addition to loads, some mutual funds also contain so-called 12b-1 fees, which are used to pay for the fund’s promotion and advertising costs. The idea that these mutual funds would charge you an additional fee beyond the fund’s normal expenses to pay for their marketing is again, ridiculous. As with loads, there is no justification in today’s financial landscape to pay 12b-1 fees. This is because, as you can probably guess, ETFs don’t have 12-b1 fees!
Aside from the fees noted above, mutual funds also charge an expense ratio, which is calculated as a percentage of your total investment. ETFs charge an expense ratio as well, but as you’ll see, the expense ratios for ETFs are substantially lower than that of mutual funds.
According to the Investment Company Institute, the average expense ratio of an actively managed equity mutual fund during 2017 was 0.78%. For ETFs, that figure stood at 0.18% … less than a fourth. At first glance it may seem trivial to haggle over a few tenths of a percent, but if you read our article on how expense ratios can cost you a fortune, then you know how big a difference this can make. Over a 30-year period, those few tenths of a percent can add up to hundreds of thousands of dollars of lost portfolio value.
At this point you should recognize that ETFs will provide higher returns than actively managed mutual funds, and will do so with lower overall expenses. That’s a win-win, and it’s one of the few quick and easy wins are that are available to investors. Now let’s briefly cover some of the other nuances of mutual funds.
Many investors don’t realize this, but ETFs also provide tax advantages that mutual funds cannot. This stems from both the legal structure of each entity, as well as the investment style.
With actively managed mutual funds, portfolio managers are regularly making changes to the fund’s holdings. These changes result in taxable events for the investors. In some cases, mutual fund shareholders can experience taxable events even when the mutual fund doesn’t have any gains … how’s that for a nice slap in the face!
In contrast, ETFs primarily track specific indexes, and since the composition of those indexes doesn’t change very often, there is almost no portfolio turnover. As a secondary benefit, the legal structure of ETFs allows buyers and sellers to trade shares with no impact to the underlying securities. Since none of the underlying securities need to be bought or sold, there are no tax implications to the investor aside from those resulting from the difference between the purchase and sale price.
In the spirit of fairness, we should mention that the tax benefits of ETFs over mutual funds are diminished when mutual funds are owned in a tax-advantaged account (such as a 401(k), IRA etc.).
Liquidity and Transparency
We’re not going to spend too much time on this, but it’s worth noting that ETFs also have added benefits from a liquidity and transparency perspective.
With regard to transparency, ETF holdings can be seen freely at any time, whereas mutual fund holdings are only disclosed to investors on a quarterly basis. In effect, those invested in mutual funds do not always know what they own. The manager of a mutual fund is free to buy whatever securities he or she wants as long as it fits within the guidelines outlined in the prospectus.
ETFs also offer enhanced liquidity. Whereas mutual funds can only be traded at one price – the net asset value (NAV) determined at the close of trading, ETFs can be traded throughout the day just like any other stock. This may not seem like a big deal, but it can have a significant impact when there is a substantial rise or fall in market prices by the end of the trading day.
By now the benefits of ETFs over mutual funds should be clear. No matter how you look at it, whether from a performance, cost, tax, liquidity or transparency perspective, ETFs provide benefits that mutual funds simply can’t match.
That said, there are a few caveats to this discussion that you should be aware of. The first is that many employer-sponsored retirement plans, as well as some other account types (such as college savings 529 plans) don’t offer ETFs as part of the available investment options. In effect, you’re forced to use mutual funds.
In this case, you’ll want to focus on using indexed mutual funds. Unlike their actively managed counterparts, index mutual funds operate just like ETFs in that they track a particular benchmark. Since there is no active manager to pay, index mutual funds also offer low expense ratios that match those of ETFs. To put it succinctly, indexed mutual funds are the ONLY type of mutual fund you should ever invest in, and only when ETFs are unavailable.
The other caveat has to do with ETFs. The vast majority of ETFs are passively managed and simply track an index. These are the kind we like. However, as the popularity of ETFs have grown, some companies have issued actively managed ETFs. These should be avoided for the same reasons as actively managed mutual funds.
In addition, some ETF issuers have tried to get fancy and offer things like “leveraged” or “inverse” ETFs. Please do not ever invest in one of these products. For reasons that are beyond the scope of this article, these investment vehicles will not deliver the performance you are expecting, and will slowly eat away at your capital due to a phenomenon known as beta slippage. Consider yourself warned.
As you can see, ETFs represent a major leap forward over mutual funds. That’s why each and every fund that is included in our investment models is an ETF. Now that you recognize the relative advantages of ETFs over mutual funds (and indexed mutual funds over actively managed mutual funds), consider taking a look at your portfolio to see where you money is allocated. If you’re like most people, you can get a quick performance boost simply by reviewing your allocations and shifting AWAY from mutual funds.