Tuesday, 23 February 2010

The Myth that ETFs are Always and Necessarily Better than Mutual Funds

It's all about costs and investment strategy. Whether a fund is an ETF or a mutual fund doesn't matter all that much. If the costs to buy into, to manage and to run the fund are low and it passively invests in a broad market index, the results for the retail individual investor will be good. The fact that mutual fund fees in Canada have been high and net investor returns have been low as a consequence does not mean it has to be so. In fact, ETFs are catching up to mutual funds in both good and bad ways. The recent proliferation of new ETFs with active trading strategies, narrow asset groupings and leveraging, foretell that investor returns will be poor.

That it is possible for mutual funds to equal the original virtues of ETFs is evident at the US fund company Vanguard, which offers both ETFs and mutual funds.

Here is a sample of funds with identical holdings and thus returns, apart from fees. In fact, the ETFs of Vanguard are merely a share class of the same asset base.

  • US Total Stock Market ETF (symbol: VTI) - MER 0.09%
  • US Total Stock Market Index Fund (VTSMX) - MER 0.18% no purchase or redemption fee
  • US total Bond Market ETF (BND) - MER 0.14%
  • US Total Bond Market Index Fund (VBMFX) - MER 0.22% no purchase or redemption fee
  • Emerging Markets ETF (VWO) - MER 0.27%
  • Emerging Markets Fund (VEIEX) - MER 0.39% plus purchase fee 0.50% and redemption fee 0.25%
The mutual fund on-going MER fees are a bit higher but for someone trying to make regular small purchases through an automatic savings and investment plan, avoiding the payment of trading commissions on ETFs, even when they are $1o per trade from a discount broker (a $10 cost on a $1000 purchase is a 1% "fee") makes the two alternatives very similar. Add in the convenience of automatic dividend reinvesting (DRIP) and tax record keeping that mutual funds offer, and ETFs lose their advantage. Vanguard even has a handy ETF vs mutual fund calculator to compare which version you would be better off to buy, considering fees, holding period, frequency and amount of purchases and commission costs.

The big problem for Canadians, of course, is that Canadians are not allowed to buy US mutual funds.

To its credit, one Canadian ETF provider - Claymore Canada - has adopted useful mutual fund features by offering pre-authorized chequing contributions (PACC) for buying its ETFs, along with a DRIP and a systematic withdrawal plan (SWP), all at no transaction cost. And all of BMO'sETF family new offer DRIP as an option, though not the PACC and SWP (yet?).

If only some mutual fund visionary in Canada would catch up to good aspects of ETFs ....


larry macdonald said...

I think actively managed mutual funds also beat index funds and ETFs in certain categories like small caps?

CanadianInvestor said...

I think I saw something like that too a while back. Good post for you to do. Ironic isn't it that when finally ETFs are getting to be widely known they get corrupted?

Anonymous said...

My bank is offering me a 5 year floating rate note with fixed rate 3% for the first two years and capped between min 3 and max 7% to the 3months USLIBOR for the year 3, 4 and 5. Am I having a good deal?

CanadianInvestor said...

Anon, you might look at some alternatives here http://howtoinvestonline.blogspot.com/2010/02/comparing-alternatives-for-where-to.html to decide whether the potential upside of the note is worth it. It seems to be in the ballpark.

Canadian Couch Potato said...

RE: the idea that actively managed small-cap funds beat the indexes, let's put this in perspective. The most recent SPIVA reports show that 52% small/midcap funds outperformed the benchmark in 2009, and that was a year when small caps were red hot. Crack out the champagne, the active managers made it a coin flip instead of their usual 80% to 90% failure rate.

CanadianInvestor said...

re small caps and funds, the principle I have seen that makes sense is that the less efficient a market is, the more opportunity to make excess profits. That means places like small caps, which receive less professional analyst attention, emerging market stocks. But if the fund managers jack up their fees - and don't the small cap managers charge more in fact? - the benefit from the better stock picking success goes to the managers, not the investor.

btw, Couch Pot., saw your website the first time today - looks good and am adding it to my blog list.

Anonymous said...

I love these blogs and think both the posters and commenters offer valuable info. But, now I think Im even more confused between fees and figuring out actual returns. Ive read the average longterm return on both ETFs and mutual funds is about 4%. Is that after fees and before taxes? Does a DRIP offer a good advantage...Ive been urged by others who swear by them.

CanadianInvestor said...

Anon2, ... hmmm 4% average, depending on who is quoting the numbers for what purpose, it could be right on or way off. Consider such factors as:
- equity vs bond funds, or subdivisions thereof; equities have higher returns over the long term, like 5.8% compounded since 1900, (see Feb.16 blog)
- inflation taken off or not; usually not when funds show returns
- fees taken off; usually some are, but sometimes it is "convenient" not to show all costs of operating an ETF or fund; annual reports give the dirty truth if you can, and care to, dissect them
- taxes; usually not shown because they cannot know what tax bracket you the investor may be in

Yes, DRIPs are very good since they avoid commissions, which can be a significant overhead to reinvest ETF distributions.

Canadian Couch Potato said...

CF DIY: Many thanks for linking to my blog. Great to be part of the personal finance blogging community!

Anonymous said...

@CI...Thank so much. Ive self educating for a few years now but finding blogs like the Canadian Capitalist and offshoots likes yours has been relief for those of who suffer from information overload. One thing has baffled me: it seems if you are looking cash holdings at returns that GICs seem very comparable to TFAs and High Interest accts. unless your willing to park your cash for a few years. Is this true?

Anonymous said...

@CI...my apologies for the typos. It seems my grammar and spelling has gone down in direct correlation with my succumbing to the technology age!

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