The Case Against Mutual Funds

The Reason ETFs Are Overtaking Mutual Funds

Every year, mutual fund managers, executives and various industry personnel gather in Chicago for the Morningstar Investment Conference to share ideas on the state of their industry. At the latest conference, according to one report, there was a conspicuously absent discussion of what I think is the biggest threat to the mutual fund industry — the rise of exchange-traded funds (ETFs).

I’m referring to an article that appeared on ETF.com and was appropriately titled, “Behind Closed Doors, ETFs Are All the Rage.” The piece correctly reported that “the ETF market is the fastest-growing segment in the financial world today, expanding at roughly a 25-percent-a-year pace and now boasting more than $1.85 trillion in assets in the U.S. alone.”

Unfortunately, the mutual fund industry wants to keep that inconvenient truth on the back burner and from you, the investor.

Investments of roughly $18 trillion are in mutual funds, including money market funds, and $1.8 trillion are in ETFs. Professionals get it. Most investment advisers are migrating to ETFs for their clients. Some retail investors use ETFs, but with one in two households in the United States holding a mutual fund, there is a long way to go for ETFs to catch up to mutual funds. Once investors understand the benefits of an ETF vs. a mutual fund, they will gladly make the leap as long as they have the knowledge to succeed.

ETFs are not complicated; they are a very simple product. What makes using ETFs hard is the fact that there are so many — now more than 1,500 funds. Some knowledge is required to build an ETF portfolio. Such information can be found through our new website, ETFU.com, my radio show, webinars and our newsletter, Successful ETF Investing. We are filling the knowledge gap that exists today with mutual fund investors so they can become proficient ETF investors. Our first step is educating and motivating mutual fund investors to look closely at the fees, costs and risks of mutual funds. That is the purpose of this report: The Case against Mutual Funds.

Several factors contribute to the superiority of ETFs against mutual funds, though the big three are fees, taxes and the failure of active management.

The Case Against Mutual Funds

Fees

If I told you where you could buy gasoline in your town for $1 a gallon, wouldn’t you go there?

Of course you would.

That’s because $1 per gallon is about a 75% discount in cost from what you pay if you’re in California. Well, it’s the same thing for investment products.

You see, the cost of owning the average mutual fund per year is much more than a comparable exchange-traded fund (ETF). Stated differently, an ETF costs about 75% less than a mutual fund — and that makes a BIG difference over the course of five, 10 or 15 years.

But why do mutual fund managers want to hide the facts? Simple: because the growing popularity of ETFs will almost certainly put the brakes on the mutual-fund-fee gravy train.

The problem in the minds of investors, though, is that it appears that mutual funds are FREE. This is not the case; you see, when people realize how much of their money is going to pay for those high-priced mutual fund managers, executives and support personnel to go to conferences such as the aforementioned Morningstar gathering, they aren’t going to like it.

The mutual fund industry also realizes investors are going to like the fact that they only have to pay a fraction of the cost in fees to own many ETFs that are essentially the same as those high-cost indexed mutual funds.

In fact, mutual funds are not required to report their fees, so investors often enter blind and blissfully unaware.

Alternatively, the funds put their fee information in documents so dense that the average investor is unlikely to dig through and access the relevant information.

And this information remains hidden even from those who do choose to invest in mutual funds: the fees are simply removed from investors’ accounts, without any notice, bill or receipt.

When these phantom fees end up being three times as expensive as those of a comparable ETF, it is easy to see why many investors favor ETFs.

I suspect that as more and more investors realize the virtues of owning exchange-traded funds over mutual funds, the mutual-fund-fee gravy train will continue to dry up. That is a great thing for you, the individual investor, because the less you pay out in fees, the more money you keep in your pocket — and the bigger you’ll be able to build your ETF nest egg.

Taxes

ETFs are far more tax efficient than mutual funds. This situation is mainly due to the high turnover of positions held by mutual funds. That turnover leads to higher taxes for mutual funds.

While ETFs follow indexes and stick to their positions, resulting in low turnover, mutual funds feature active management. These managers are responsible for mutual funds’ high levels of turnover, since they target specific concentrations in fewer stocks and readily move in and out of these positions. Because of this, wholesale liquidations are much more common for mutual funds, which thereby incur capital gains taxes.

In addition, a change in managers can result in a complete portfolio revamping, triggering taxes on the previous manager’s gains.

Every change in a mutual fund’s portfolio is considered a taxable event. In addition, mutual funds feature an annual tax, which hurts long-term performance.

A mutual fund investor might even end up paying someone else’s taxes. This is due to the timing of mutual fund distributions to shareholders: at the end of the year, all investors are taxed for the performance of the mutual fund over the entire year, no matter when they entered the fund.

ETFs, on the other hand, as index-based investments, are structured differently and therefore avoid many of the tax issues that cripple the returns of mutual fund investors.

Failure of Active Management

For the most part, mutual funds don’t beat the index or benchmark they’re tracking. Mutual funds feature active managers who are constantly looking to generate profits, while ETFs passively follow the results of an index.

Research shows that 75% of mutual funds underperform their underlying index. A mutual fund manager could put together one or two strong years, but the results will revert to the underperforming mean eventually. Couple that with the aforementioned issues with fees and taxes, and mutual fund investors pay more for worse results. In contrast, ETFs are pegged to an index, so their consistent performance matches that index automatically.

In addition, many investors let their money just sit around in mutual funds, accruing the burdens of fees and taxes. Since ETFs are traded like stocks, investors are encouraged to keep an eye on their positions and trade actively and intelligently.

Other Factors

In addition to these three main pillars, a few other factors contribute to the superiority of ETFs.

Lack of access: Mutual funds do not invest in commodities, currencies or alternative strategies, nor do they give investors the flexibility of ETFs and access to investments like single countries, sectors, emerging markets, industry groups, leveraged funds, etc.

Innovation: There is very little new innovation going on in mutual funds today, since launching a fund is very expensive and the marketplace is very crowded. But there are hundreds of new ETFs coming out every year. All of the innovation is happening in the world of ETFs.

The vast number of new ETFs allows for many more “experimental” funds that explore sectors that mutual fund company management teams couldn’t imagine entering. A look through these more offbeat ETFs could uncover dozens that may be a good fit for your portfolio.

Liquidity: During the financial crisis in 2008, many investors who redeemed their mutual funds during the bottom of the crisis saw their investments sink in value. The reason a mutual fund is a bad vehicle in a down market is because, as redemptions occur, a portfolio manager will sell the most liquid investments, their best stocks and bonds. As the redemptions pick up, they are faced with selling less liquid assets and getting bad pricing. This situation holds especially true with bond funds.

In addition, there is now talk of imposing a redemption fee on less liquid assets. Also, if you have investments of $200,000 or more in a fund, you may end up receiving stock rather than cash if you want to redeem,.

In other words, it’s more difficult to exit a mutual fund, as you can get hit with penalties and fees for getting money out. Plus, when the next market correction hits, the mutual fund companies will sell their best assets first… But if panic ensues, and investors want to sell, the less liquid assets/positions will be left and exiting expediently may not be available.

To Sum It All Up

I hope this report encourages you to invest in exchange-traded funds. For my recommendations, see the latest issue of Successful ETF Investing.