Investing In Mutual Funds versus Exchange Traded Funds
Mutual Funds are pools of funds invested in some combination of stocks, bonds or money market funds. A defining characteristic of mutual funds is that the fund manger allows you to buy or sell units at the net asset value as calculated at the end of each trading day. When you place a buy or sell order you transact at a future closing price that is not known at the time you enter your order.
Mutual funds are available to cover virtually all asset classes and all regions of the world.
The fund manager charges an annual management fee that is often in the range of 2.5% but which varies quite widely. A portion of this fee often goes to the mutual fund dealer who sold the mutual funds to an investor. This is an upfront commission and an ongoing (trailer fee) income for the mutual fund dealer. The manager is also typically allowed to charge certain expenses such as trading fees directly to the fund.
Some mutual funds charge fixed fees upon purchase (front end loaded) or charge redemption fees upon sale (back end loaded). In recent years most new mutual funds are no load funds.
Reasons to Invest in Mutual Funds:
1. Independent Mutual Fund Dealers Sell Investors on Mutual Funds
This is a valid reason to be invested in mutuals. Many investors need the guidance of a financial planner. The usual system is that the investor is not paying any fee to the planner. The financial planner gets paid through trailer fees and an up-front sales commission that are part of the (hidden) management fee charged by the fund. These fees are hidden and not apparent to the investor.
Given that most investors need advice and are not usually willing to pay separate fees for advice, this system works reasonably well. In some ways it is also superior to the old system of obtaining advice through a brokers since with mutual funds the advisor does not have an incentive to churn your account.
2. Investors Buy Mutual Funds to Achieve Diversification
Some individual investors select a broad based equity mutual fund in order to provide diversification. This is not a very efficient method of diversification. In this case the investor is paying for advice that they are not using. Diversification can be better achieved with exchange traded funds which offer much lower management fees.
Investors who are in mutual funds of their own choosing to achieve diversifications should consider selling their mutual funds and replacing them with exchange traded funds. (Check first if redemption fees apply).
3. Mutual Funds for Specific Sector Exposure
Specialized mutual funds can provide exposure to a broad range of segments such as biotechnology, emerging markets, gold, real estate and many many others.
This is a legitimate reason for using mutual funds. However new Exchange Traded Funds are rapidly being introduced that will provide these exposures at a far lower management fee. Investors should consider switching to Exchange Traded Funds.
4. Mutual Funds For Superior Performance
Many Mutual funds are sold on the basis that the fund is expected to beat the stock market index.
In a few cases this may be a reasonable assumption. If an investor has done their homework and believes that the manager will be able to beat the applicable index (after deducting management fees) through stock picking skill then it is logical to hold that fund.
But realistically, this will seldom be the case. My understanding is that the great majority of stock market funds are either professionally managed or are in index funds. If this is true then it is a mathematical imperative that the index will be set by and will be about equal to the performance of the average professional manager. Deduct management fees and it becomes a mathematical necessity that the average professional manager will underperform the index by about the amount of the management fee. Furthermore, studies have shown that a different group of professional managers will tend to out-perform each year. Very few managers outperform on a consistent basis.
Therefore, unless an investor has strong reasons to believe otherwise, he or she should assume that his mutual fund will not outperform the index and therefore should sell it and buy an Exchange Traded Fund.
Again, this does not apply if you are using the services of a Financial Planner. If you want and need that service, then you need to pay for it some way.
5. Mutual Funds for Small Monthly Investments
Mutual Funds allow monthly investments as low as $50 per month. It is not cost effective to invest small amounts like this in Exchange Traded Funds, due to trading commissions. Therefore, this is a legitimate reason to hold mutual funds.
Invest in mutual funds if you are getting good advice and service from a financial planner who is compensated by fees from mutual funds. Also invest in mutual funds if you have good reason to believe that a particular manager can beat the index, even after management fees. Use mutual funds to invest in specific sectors where exchange traded funds are not available.
In almost all other cases, sell your mutual funds and invest in Exchange Traded Funds, to lower your management fees and reduce risks.
Invest in individual stocks only if you have access to a trusted source of analysis or can undertake your own analysis.
Shawn Allen, CFA, CMA, MBA, P.Eng.
January 9, 2003