ETF or Mutual Fund?

$2 trillion was held in 1,411 ETFs in the US at the end of 2014, per ICI, now holding more assets than hedge funds.  This is dwarfed by the $16 trillion in mutual fund holdings, but ETF growth continues to outpace mutual fund growth.

The April 2016 DOL rule regarding the fiduciary duty of the financial advice industry may also drive some additional AUM to ETFs.

What are factors to consider when selecting between mutual funds and ETFs?  Start with costs.

  1. Taxes:  Because of the way that the funds are structured, ETFs often have lower tax costs than mutual funds.  This is an “all other things equal” kind of generalization.  All other things are often not equal, so be sure to verify recent tax impact of funds being considered.
  2. Trading Costs:  ETFs will incur several types of trading costs.  The one the investor sees is the trade commission.  In addition, there is the trading spread, which can be substantial, and is always present, and the premium or discount to NAV, which can actually work in the investor’s favor.  Mutual funds can have a sales load on the purchase or sale as well as transaction fees for each purchase and sale.  Mutual funds also have varying penalties if sold before specified holding times.
  3. Fees:  ETFs have a set fee, but check for a fee waiver that may expire.  Mutual funds have expense ratios, but can also have 12b-1 fees.

Next, consider what the funds are, especially in comparison to what they say they are.  Index funds should actually match (or be close to) the performance of the index, and not all of them manage to do that.  Conversely, actively managed funds should not match up closely to an index.  See ESMA.europa.eu for research on closet indexing.  The following metrics are useful for both ETFs and MFs, although not always easily found:

  1. Active share measures the percentage of a portfolio that is different from its benchmark.  This is normally only measured for actively managed mutual funds.  One source for this information is mutualfundobserver.com.
  2. Tracking error measures the volatility of relative returns for a portfolio compared to the fund’s benchmark.
  3. And of course, the bottom line is the total return that the investor receives compared to the benchmark.  You can find information comparing the benchmark to the fund performance in the fund’s annual report.

These should be looked at for at least 1 and 3 year time periods, or as long as the current management team and process have been in place.  Note on active share:  Do not confuse active share with performance.  See Financial Analysts Journal, March/April 2016 (Frazzini, Friedman, Pomorski).

The December 2015 issue of this publication featured an article by Eric Robbins explaining NextShares, which is a way that ETFs can include active managment.   To find active ETFs that are similar to active MFs, start with the stated objective of the fund.  Check the style box, the sector breakdown, the number of securities held, and the turnover.  Obviously, performance should also be similar for the funds to be considered equivalent.

What about the “active index” or “smart beta” ETF products?  They are sort of in between active and passive products, and generally there are not both ETF and exact MF versions of these funds.  Like actively managed funds, compare the stated objective and measurable characteristics to determine if an ETF and MF are suitable substitutes.

When comparing actively managed funds to an index fund, the duty of a fiduciary is to know that any added cost of active management will result in a fund that is materially different from an index fund, and expect that the real net total return over the anticipated holding period is equal to or higher than that index fund.

Mutual funds have advantages in the following situations:

  • Client who is dollar cost averaging.  If you find a fund with no trading fees and similar expenses to the best ETF available, the monthly trade commission may make the ETF more expensive, especially for smaller amounts invested.  In addition, the client can always be fully invested in MFs, with no residual cash on hand.  Administration is also simpler from the advisor’s end.
  • Client investing in index funds in a tax advantaged account.  This eliminates the tax cost advantage of the ETF.  If you have access to institutional MF shares for the client, they can be cheaper than ETFs.
  • Investor has a strong preference for a specific active fund manager or fund family.  Be sure to look at the few active ETFs that are out there also.
  • You are investing in a market or asset class that doesn’t have an index for what you want to own.  Examples: China, with its large assortment of share types, markets, company ownership (SOEs, etc.), and even currency.  Bond markets (lots of people own AGG, but does anyone like it?).  Alternative investments, like futures or CTA-type funds.

ETFs may be the best choice in other cases:

  • Client who is investing in taxable account.   The exception to this would be if the amount invested is small compared to the total trading costs.
  • The client or advisor has a strong preference for passive investing, or factor investing (smart beta).  Although you should check for MFs, especially for the most common indexes, costs are usually lower for ETF index funds.
  • Rules based investing models (tactical asset allocation), where trades are made based on price levels.  Intra-day trading allows for technical trading of ETFs.

The choice between a mutual fund and an ETF is not always obvious.  As the ETF market expands, and fiduciary requirements increase, it is becoming more important to consider both alternatives for any given investment objective.

 

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