What’s all the hype about Exchange Traded Funds (ETFs) over Mutual Funds?
by Jennifer Schell, CEO and Founder of Finliti
I hear it a lot: I hate mutual funds and I want to switch all of my investments into ETFs.
Okay Investor, but what’s the fact-checked truth? To start, it may be useful to know the key differences between mutual funds and ETFs, (which is an abbreviation for “Exchange Traded Funds.”)
I would say that one of the key differences is “active” vs. “passive” management. Both ETFs and Mutual funds are portfolios and they give you some elements of diversification. Either way, you are giving up the control of selecting the investments that you want in a portfolio and you are buying a broad-based solution.
“Active” vs. “Passive” Management
Active management is when a financial professional, (usually called a PM for Portfolio Manager), is making deliberate choices for your portfolio – whereas passive investments are when the Portfolio Manager licences a replica of an index.
Mutual Funds tend to be actively managed. Here are the BENEFITS of mutual funds:
Managed: There are some quality managers who are very good at what they do and who have an excellent performance track record. To track the performance, there is a system called the “Morningstar Rating” that gives a shout-out to the managers who are doing well in any given year. Managers are like all-star athletes… they usually have a period of glory-time and then their strategies fizzle out as the market conditions evolve. Below, I have included a sample of the Fund Fact document, which illustrates the pertinent facts about the mutual fund. ETF’s have one too.
One key advantage is that active mutual fund managers try to manage the downside risk of a portfolio so that when the market falls, your investments will not fall as hard. Contrary to the media, some managers do outperform the market. In this case, it’s worth paying the extra money to them for proper management.
Busy people and for those who dislike investing: Mutual funds are ideal for busy people, people who have advisors and for those who dislike investing. This is one way where you can set it and forget and let the strategies act for themselves.
Calculation: Mutual funds have an end-of-day calculation, so you can only track the performance at the end of each trading day. They are valued according to the Net Asset Value (NAV) which represents the fund’s market value per share. The NAV is calculated by dividing the total value of all the cash and securities within the fund’s portfolio of investments, less any liabilities (such as trading costs, foreign exchange fees, interest costs from borrowing, etc.), by the number of outstanding shares. The NAV essentially indicates how much one share of the fund is worth. This is important, because when you buy into a mutual fund, your transaction is held until the end of the day, once the markets are closed and the NAV price is set. A mutual fund transaction is between the client and the fund company, directly.
Investing is an emotional process and making emotional decisions about the stock market can make or break you. Leaving it up to a manager with a process in place can reduce the emotional ups-and-downs that come with investing. This is why mutual fund investing is encouraged by the industry – it’s to avoid liability and losses from emotional decision making on behalf of inexperienced or irrational investors.
Poor Performance: The problem with some mutual funds is that they can be mass-produced and not properly monitored. This occurs when a company has too many offerings and not enough people monitoring the solutions. It takes time to monitor and track a portfolio of holdings and sometimes, a lack of performance can be blamed on an old school manager who refuses to adapt to change.
High Fees: The mutual fund most likely charges a fee called an MER, which includes the operating expenses, the manager’s compensation and also compensation to your advisor or bank. Mutual funds can charge fees from 0.85% up to 3.75% in some cases. If you’ve ever run into segregated funds (insurance), these fees may even range up to 5% in any given year. You can imagine how frustrating it is when your fund doesn’t perform and you are left paying fees that erode your capital for nothing in return.
Early redemption Fees (DSC) Deferred Sales Charge: Please be hypervigilant of these fees.
When you purchase a mutual fund, there are often fees assigned for early redemption, called back-end fees. In addition, if you change your mind, there can be an early redemption fee, starting at 1% of your full investment amount. Even if it’s a fee-based mutual fund, there might be an early redemption charge if you sell in less than 90 days.
Terms vary: some countries and financial institutions have eliminated DSC fees entirely, but many have not. When you have an advisor, this is something you should ask them about. DSC charges were created to prevent you from selling out of a mutual fund and were meant to encourage you to “stay the course.” Your financial advisor is also compensated by these fees.
The disadvantage is that your investment may be locked-in with one company for up to 7 years.
There is a DSC schedule that should always be provided to you… As time goes by, the fees reduce to zero. (Please note that In Canada, DSC fees will be banned as of 2022, except in Ontario.)
Tax inefficiencies with year end distributions: If you buy a mutual fund at the end of the year, you may be subjected to taxes on year-end distributions. This is especially annoying if you have a non-registered account that is taxable. When mutual funds distribute earnings, even though you only just bought in, you could be on the hook for paying others’ taxes on the distributions.
Limited Transparency: If you pull up the Fund Facts document online with the name of your desired mutual fund – into a google search— you can usually see the top 10 holdings of the portfolio. As mentioned, the funds are calculated at end of day using an “NAVPS” calculation.
What this means is that the value of the stocks, bonds or other type of equities are recorded to give you a report of the value of your mutual fund investment that day.
Exchange Traded Funds
Exchange Traded funds gives you part ownership of a basket of securities that usually track a specific market index, such as the S&P/TSX, Nasdaq or even a specific sector, like silver commodities. Most ETF’s are passive, but there are many that are also managed by a Portfolio Manager. These are considered “active strategies.”
Transparency: The key difference is that the holdings are transparent. You can see exactly which equities, being stocks, bonds or other assets that you hold at any given time.
Usually lower cost, (but not always): ETFs are a vehicle that aim to provide a lower cost structure to a basket of equities, such as stocks or bonds. Contrary to popular belief, some ETF providers charge fees comparable with some mutual funds. Pay attention to the fees on an actively managed ETF, because they do exist. Pull up the Fund Facts to view these charges. The passive ETFs are cheap and sometimes free.
Tax Efficient: It can be easier to track the accounting of these ETFs and although they have dividends, some of the dividends are built in and don’t pay out – which can be beneficial for non-registered accounts. Also, because of their passive nature, there are less transactions occurring in the ETF and therefore, less capital gains are triggered. Depending on your country of residence, a domiciled ETF provider may provide additional tax advantages that prevent additional foreign taxes from being incurred.
Dangerous: Some ETFs can have weird structures and are specific for day-traders or fund managers to hedge their risk. Be mindful of highly-leveraged ETFs that can cause violent ups and downs on any given day. Other ETFs with fancy names, such as bear-market ETFs, are “reset” at the end of every day. This means that if you don’t get rid of your investment that day, your entire investment will eventually erode to zero over time.
Liquidity: The bid and ask spread can be very far apart. When you buy an ETF, you may actually be buying it from a market maker, who’s job is to provide liquidity and pricing to your ETF. This sometimes leads to arbitrage opportunities for institutional firms, which negatively impacts ordinary clients. On inactively traded ETFs, the bid and ask spread may mean that you pay more for a holding or you may receive less than the true underlying value if there is no market or if it is a thinly traded position.
Limited Down-Side Protection: ETFs are little pictures of the real market. When the market takes a tumble, so do you. When the market is hot, so are your portfolios, but when the market gets moody and decides to retract, your investments can fall with it.