Back To Investing Basics: Mutual Funds or ETFs?

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Okay, it’s official. I am now thoroughly bored with the current manufactured political crisis. It’s not that the consequences don’t have the potential to be dire; it’s just that the media (including me) have a tendency, or even a duty, to look at the worst possible outcome and make suggestions based on that. I will repeat what I said at the beginning. The most likely outcome is still a last minute compromise with disaster averted. In that case any falls in the stock market will look like blips on the chart in a few years and will represent buying opportunities.

With that in mind, many people will, sometime soon, be looking to put money back to work, so one of the basic questions that investors face is worth asking again. Should you use mutual funds or ETFs for investing? I hate to sound too much like the Financial Advisor I was, but the answer, of course, is “It depends on your investment objectives and time horizons.”

The problem with any phrase that FAs use frequently is that after a while the actual meaning of it is lost. Most people hear “Blah, blah, blah, blah…” when somebody says the above or “Past performance is no guarantee of future results.” These phrases are based on truth, but have more to with protecting the advisor and his firm from any potential complaints than actually giving you information. While past performance is no guarantee of future results, for example, success over a long period of time is still the best guide we have.

In the case of mutual funds vs ETFs and their suitability, it is important to keep in mind that it is not an either/or decision; you can have different goals and time horizons simultaneously and therefore have use for both. Most people who actively follow markets divide their money. Some is set aside for long term growth and some is used to “juice” returns by more active investing. In this scenario, both tools have a purpose.

Mutual Funds:

Mutual funds have, for many years, been the basic tools of long term retail investors. Money invested in the funds is pooled and used by the fund’s manager to buy and sell stocks. Your shares represent part ownership of the portfolio, giving the small investor an opportunity for diversification and relatively inexpensive access to professional money management.

The rules of most funds penalize investors who try to sell too quickly after they buy, as mutual funds are designed for long term holdings and this is what they should be used for. Because of this, which funds you chose is important.

My first piece of advice would be, don’t invest in too many. Some people think that, by spreading money between five or six stock funds they are reducing their risk. I don’t believe they are. A lot of the time, Large Cap Growth funds, for example, have very similar holdings. By buying multiple funds you are not really diversifying. Add to this the fact that in 2012 over 66% of US equity funds underperformed versus the S&P 500 and you can see that by buying too many funds you are just increasing the chance of one or two bad ones becoming a drag on performance. My preference is for one general US equity fund, one US bond fund, and one international balanced fund.

Secondly, don’t become too fixated on fees. I know… that is contradicting the current conventional wisdom. Studies have shown that, over time, fees are the most important factor in determining returns. The problem is that these studies look at all funds, or funds on average. As I said above, around two thirds of funds underperform the market, so inevitably, when you look at the average, higher fees hurt.

I would rather look for mutual funds that have stable management who have consistently outperformed on an after fee basis. The Oakmark Fund (OAKMX), for example, is managed by Bill Nygren and Kevin Grant, who have been with the company for 30 and 25 years respectively, and, since the fund’s inception in 1991 has returned an annualized 12.79% versus an 8.94% return on the S&P. The 1.03% expense ratio on the “no load” shares means that the fund would be missed by those basing their decision primarily on cost. A fee is only expensive if it returns no value.

ETFs:

Exchange Traded Funds, or ETFs, are similar to mutual funds in many ways. They too pool investors’ money to invest in a portfolio. There are, however, two major differences. ETFs are, as their name suggests, bought and sold on exchanges. They are traded like stocks. Also, most (but not all) ETFs are designed to reflect the performance of a particular index, so the stocks or bonds owned change very little. This passive style allows for lower fees than most mutual funds.

ETFs are gaining ground with investors every year, but I still prefer mutual funds with a proven track record for core investments. I believe the reward for outperforming the market is worth the risk of not doing so. In certain areas, however, the flexibility that ETFs offer is invaluable.

More volatile sectors such as Small Cap stocks, high yield bonds and emerging market securities are areas where ETFs can be much more useful than mutual funds. The flexibility of being able to buy and sell shares quickly and cheaply is invaluable here, and even quite conservative “buy and hold” types can benefit by a more active trading style in these areas.

ETFs also offer the advantage of allowing investors to switch readily between different sectors and industries. Again, this is not something to get carried away with if you are investing for the long term, but often using a small percentage of your total portfolio this way helps you to leave the majority of it in place and not panic when the going gets tough.

For some experienced trader types, the above is probably of little interest, but we all benefit from an occasional review of the basics when it comes to investing. As the current crisis unwinds, it is likely that many people will be looking to re-invest money that they had taken out of the market as a precaution. If you are one of them, then I believe a mix of long term holdings in carefully selected mutual funds and more actively traded ETFs gives you the best chance of success.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , ETFs , Mutual Funds

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Martin Tillier


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