Mutual Funds Are Outdated, Here’s Why ETFs Are Superior

Originally published on Equities.com, September 27, 2016.

In the 90s, video cassettes were succeeded by DVDs, which were then succeeded by Blu-ray players, which were most recently succeeded by digital and 4K. As new things emerge, things that were once current and common become obsolete – it’s the natural order of things. The gold standard for long-term investments through much of the 80s and 90s were mutual funds. More specifically were the actively managed mutual funds that provided not only diversification but also professional management. Much like the video cassette, Walkman, and Gameboy these too have been vastly improved upon and succeeded and are now obsolete.

Starting in the late 90s the SPY or the S&P 500 exchange traded fund (ETF) became available. When exchange traded funds came onto the scene they almost immediately made most mutual funds obsolete. To compare the two we first have to know the similarities and differences between the two products. First and foremost, why would someone invest in a mutual fund in the first place? Mutual funds offered of the promise of diversification by spreading out the risks between dozens and sometimes hundreds of individual equities. This meant that even an unsophisticated investor would be able to invest in multiple products. Who is the person who decided to put these equities into the fund? That was the job of the mutual fund manager. The mutual fund manager is responsible for the performance of the fund and to bear the burden of responsibility for the total picture of diversification of that fund. This also reduced the cost of an individual investor from buying individual securities and allow them the freedom and flexibility to participate in market growth. The downside of the mutual fund was the inability for the fund to profit in a down market, or the ability to protect one's investments in case of a large market correction.

The exchange traded fund has the ability to trade in a down market (also known as “being short”), as well as the ability to provide intraday protection against market moves. The difference between the two is really how they are created. In the case of a mutual fund, the mutual fund company gathers assets from clients and uses those assets to purchase equities which create the fund. By having the money first and the equities second, the fund does not trade throughout the day, but rather has an end of day settlement price. In order to calculate this end of day settlement price the market has to close; so, any large intraday market moves would not be realized by a mutual fund holder. This has its positives as well as its negatives.

One positive is that an investor may not overreact to one day market moves; one negative is that it will allow undisciplined investors to become complacent and hope that the market will always come back. This hope that the market will always come back was realized for the 80s and the 90s; however from the year 2000 to today, the market while still up is only up an average of a little over 2.5% per year with most mutual funds underperforming the S&P in general.

Conversely, an ETF is created by the fund company acquiring equities to build the fund and then selling shares to individual investors on the open market. The equities purchased by the fund company that created the ETF now are tradable on an intra-day basis. This allows investors to put a protective stop loss on these positions; it also allows investors to short these positions. For those that are not familiar with the term "shorting," it simply means profiting from the sale of a security as its price falls. While shorting cannot be done in an IRA, it can be done in most margin and margin-type accounts, giving investors the ability to profit in both market directions as well as have a protective stop loss on their positions.

Consider now two specific examples for comparison. They are two very similar products that both have similar investment objectives: S&P 500 index mutual fund and the SPY (S&P 500 ETF). On the surface you would think that these two products would be identical. You would also think that these two products would provide identical returns. You would probably be mistaken. Though they are both pictures of the performance of the S&P 500, one has the ability for protective stop losses, and the other does not. One has the ability to be shorted, and the other does not. Then, of course, there is the discussion of fees.

Typically, the fees in a mutual fund will be significantly higher than those of an ETF. The cost of these fees overtime will greatly erode your account as they continue to add up. Many people have heard about the concept of compound interest which is a beautiful thing when it makes you more money, but it also can work against you when it comes to compounding fees. The more time someone spends in a mutual fund the greater the effect these fees can have; many studies show that the fees in many traditional 401(k) plans can eat up almost half of the income of those plans over a 30 year span. Why are mutual funds in our 401(k)s instead of ETFs? Those very same fees are the exact reason, and most people don't even know to ask their employer about adding ETFs as an option in their 401(k)s, which would save them potentially thousands of dollars in fees over their lifetime.

Since you don't use your VCR to watch a movie and you don't use your Polaroid to take a photograph, why are you still using mutual funds as investment vehicles? If you have not yet discovered how ETFs can change your entire investment landscape, it's time to start living in the present.

Originally published on Equities.com.

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