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The great ETF vs. mutual fund debate

by | Sep 30, 2015 | SELF-PUBLISHED

Should you switch to ETFs for their lower MERs?

The lower management costs of exchange-traded funds compared with mutual funds seem almost too good to be true. Many do-it-yourself investors are wondering whether they should switch completely to a portfolio of ETFs. But a word of caution: ETFs have a few “cons” to go along with the “pros” of lower costs.

An exchange-traded fund (ETF) is an investment fund that is designed to replicate the performance of a specified underlying index, commodity, or basket of stocks. ETFs trade on a stock exchange, and can be bought and sold just as you would a common stock – complete with trading commissions. Because ETFs trade throughout the day, shares are priced according to the market’s bid/ask process, instead of being calculated as a net asset value just once at the end of each day as mutual funds are.

The ultimate “hands off” investment

Exchange-traded funds are considered to be “passive” investment funds, because most track an already established index (for example, the S&P/TSX Composite Index or the S&P 500 Composite Index). As a result, their management costs are reduced considerably, as the fund does not need to research investments or make active trading decisions. It simply needs to replicate the assets of its underlying index so that the fund’s overall performance tracks the index as closely as possible. To achieve this, ETFs may actually hold the same assets in the same proportion as the underlying index, they may take a “sampling” of the index, they may enter into certain agreements called “swap” or “forward” agreements with third parties who will provide the index returns.

Note that as with mutual funds, investors don’t actually own the underlying assets of the ETF. Instead, they own shares of the investment company or trust (depending on how the ETF is legally structured), and are entitled to share in dividends and gains received by the fund.

Market returns at lower cost

The theory behind passive indexing is based on research over the past 50 years showing basically that in broad, general terms, long-term index returns match or exceed returns of “actively” managed portfolios. Developing funds that track indexes should therefore match long-term index returns, but at a much lower cost than for actively-managed portfolios.

For example, the typical actively managed Canadian equity mutual fund charges something north of 2% in fees and costs, typically calculated as a management expense ratio (MER). The problem is that this eats directly into your mutual fund returns. ETFs, on the other hand, typically have MERs of less than 1%. So the big debate these days is whether it’s better to invest in “actively managed” portfolios and pay the higher fees or in “passive” index-tracking ETFs with lower fees.

Pros and cons

As usual, there are pros and cons to each approach. Broad, index-tracking ETFs will do just that, as was amply demonstrated through August, when global markets were hit with a bout of volatility that took many indexes, and their related ETFs, into correction territory (that is, a loss of 10% or more in value from a recent high), while gyrating with stomach-churning intensity. For holders of broad-index ETFs, there was no alternative but to hold on, other than selling the ETF outright of course.

Actively managed equity fund portfolios were subject to the same volatility of course, but depending on their mandates, managers may have been able to reduce overall portfolio volatility either by anticipating a market downturn (an exceedingly difficult thing to do, and thus quite rare) or by executing various defensive tactics, including option strategies. Admittedly, some actively-managed mutual funds have a long track-record of very good performance with reduced volatility. Some also manage to exceed long-term index performance. And these are typically only the very cream-of-the-crop funds, with multi-year Fundata FundGrade A+ Awards to their credit – again, a very rare achievement.

There are now over 500 ETFs and variants listed in Canada, with a total of $84 billion of assets under management as of the end of August. That’s still considerably less than the $1.21 trillion of assets managed by Canadian mutual fund companies (as of August 31, 2015), but the number has been growing steadily.

Consider other factors too

There are, of course, many considerations when choosing a fund, including volatility, calendar-year performance, and so on. All of this information is readily available through the Fund Library’s fund databases for both ETFs and mutual funds.

I wouldn’t recommend jumping 100% into ETFs without consulting with your advisor first. There are definite dangers to committing yourself to any single investment vehicle or asset class. If you’re concerned about the high cost actively managed fund portfolios, which do tend to have higher MERs, you can ask your advisor about structuring a “passively managed” segment to your portfolio using ETFs. You’ll at the very least start building in index-tracking performance at a lower cost.

© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

© 2023 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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