The debate between mutual funds and Exchange Traded Funds (ETFs) has been one of the hottest topics in financial circles since ETFs hit the market. They’re both smart choices for investors with small portfolios and absolute staples for Couch Potatoes. It’s trendy to say that ETFs are the smart choice for today’s savvy investor, but that may not always be true. Let’s review exactly what mutual funds and ETFs are and which one is right for you.
With a mutual fund investors contribute and withdraw money directly to and from the fund, there’s no trading between investors. These funds allow investors to pool their resources to take advantage of services they wouldn’t otherwise have access to. Mutual funds provide instant diversification and allow investors to make regular contributions without incurring trading commissions.
For example say you have a small portfolio of $10,000. Picking individual stocks involves a lot of research and analysis. Even if you have the time and knowledge to do it, you wouldn’t be able to diversify cost-effectively. You never want to put all your eggs in one basket, diversifying helps manage risk by spreading out your bets. Many consider it wise to hold at least 20 securities in order to be properly diversified. That means you’d have only $500 to invest in any one stock. If you’re paying $30 commission per trade ($30 to buy and $30 to sell) through a discount brokerage, your picks need to increase in value by 13% just to break even! Holding just two or three mutual funds can offer all the diversification you need, and there are no commissions to buy or sell.
The disadvantages of mutual funds are hidden costs, lack of flexibility and transparency, and high management fees. In addition most mutual funds offered in the past have been “actively managed” funds. The track record for these types of funds is in general, not very good. Actively managed funds can have very high Management Expense Ratios (the MER is an annual fee you pay for the administration and management of the fund) usually between 2 – 4% of you holdings. In active funds the fund manager selects and modifies the holdings of the fund on an ongoing basis, which takes a lot of work and staff. The prospectus for actively managed funds will explain the mandate and objectives of the fund manager.
Unfortunately this “professional management” your high fees pay for is rarely worth it. Few actively managed funds ever match, let alone outperform, their benchmarks or the broader markets. Mutual funds are still widely associated with active management, which is increasingly seen an expensive way to underperform the markets. In the face of ETFs which offer rock-bottom management fees, superior flexibility and a plethora of passive index funds some pundits are convinced that mutual funds are obsolete.
Like mutual funds ETFs can be actively or passively managed. A “passive” fund means the holdings of the fund match those of an index. These funds charge much lower management fees (0.25% – 1% MER) because the fund manager simply replicates the holdings of the underlying index. It’s in the field of index funds that ETFs have clobbered mutual funds.
ETFs are like mutual funds 2.0. An ETF is essentially a mutual fund divided into units that are bought and sold like stocks. It is a “fund” (a pool of investors’ money) divided into units which are “traded” over an “exchange” (such as the TSX) between investors. Hence the name: “Exchange Traded Fund”.
ETFs do offer a lot of advantages over mutual funds, but depending on the size of your portfolio mutual funds might still be your best option. The mutual fund industry has changed in response to the ETF threat over the last decade. A lot of mutual fund companies now offer low-cost, no-load, passive funds.
High mutual fund fees have long been the bane of wary investors, but this is changing. For example the TD US Index – e (a mutual fund) which replicates the S&P 500 index has an MER of just 0.5%. For a fixed income alternative the TD Canadian Bond Index – e mutual fund has an MER of just 0.49% and tracks the DEX Universe Bond index. With low cost offerings such as these it’s easy to see that mutual funds are still very much in the game.
The essential difference between mutual funds and ETFs is the difference in cost structure. Mutual funds cost nothing to buy and sell (though beware deferred sales charges) but charge higher annual management fees. ETFs, like stocks, cost trading commissions to buy and sell, but have lower annual management fees.
One of the most reliable principles for saving and investing is dollar-cost averaging – making equal contributions at regular intervals. This is why mutual funds are still relevant. Dollar-cost averaging is easily achieved by setting up a pre-authorized contribution plan (PAC) with your bank to your RRSP or TFSA, usually on pay day. The funds are invested as soon as your paycheck is deposited and before you have a chance to spend it. This is the savings angle, it ensures structure and discipline.
From an investment point of view, dollar-cost averaging ensures that you buy more shares when they are cheap and fewer when they are expensive. (Your contribution buys more when prices are low, and less when they’re high, remember the dictum “buy low, sell high”?) Over the long term the added returns brought by dollar cost averaging – especially through periods of market turbulence – will make a huge difference to your bottom line. This is where low-cost mutual funds have the edge over ETFs for small investors.
When you buy units of an ETF you pay trading commissions which typically range from $20-$30 per trade with a discount brokerage. If you’re dollar-cost averaging by investing $250 every two weeks ($5500 per year) you’re paying 8%-12% in fees just to buy! This is not a feasible plan for building wealth, fees are eating you alive. In order to keep trading costs to a reasonable level you’d have to contribute $2,000-$3,000 each time. This makes dollar cost averaging difficult. You’ll probably have to save up for a few months before manually transferring the funds to your investment account (giving you plenty of time to spend it). The danger is particularly acute during a market correction. Fear may cause you to hold on to your money at the precise time you should be buying (buy low remember).
Advantage mutual funds: There are no trading commissions to buy or sell here. Even though management fees are higher, they can still be very reasonable. You should be able to find a fund that suits your goals with an MER under 1.5%. If you’re dollar-cost averaging with modest amounts, saving on trading commissions will more than offset the cost of a higher MER. For example, the difference in MER between the iShares S&P 500 Index Fund ETF (0.25%) and that of the TD US Index – e mutual fund (0.50%), is a mere 0.25% – or 25 cents for every $100. Not completely insignificant, but a small difference.
As with any product it’s the responsibility of the individual to be prudent when choosing an investment vehicle. Some mutual funds have hidden fees and/or deferred sales charges that aren’t automatically disclosed. You may end up paying an arm and a leg when you go to sell. It’s your responsibility to thoroughly inquire about and understand the fee structure of a fund before you buy. Certain ETFs also carry risks for ill-prepared investors. Beware those holding commodities futures (as a rule do not buy commodity ETFs) or so-called ‘leveraged’ funds like those in the Horizon Beta-Pro series. Specialty funds such as these with complex holdings can behave erratically and are not suitable for most investors. A reasonable degree of prudence should be applied when investing. Neither mutual funds nor ETFs are free from risk, but risk can be mitigated by due diligence.
Mutual funds and ETFs are essential options for novice and small investors. If your portfolio is smaller than $75,000 you probably don’t have the capital to pick individual stocks or bonds; trading commissions will prove too costly. To help reduce your risk when investing with these products, apply the two-minute rule: If you can’t understand how a fund works within two minutes, it’s too complicated. Bottom line is there’s no clear winner between mutual funds and ETFs. Which one is right for you depends on the size of your portfolio, the size and regularity of your contributions and your discipline to save.