Benefits of ETF's versus Mutual Funds?
Is one better than the other?
In our long term strategic investment portfolios at Huckstep Asset Management, we include both Active Mutual Funds and Passive Exchange Traded Funds (ETF's). We are occasionally asked about the differences between the two. This write-up does not go into great detail about how each of these investment vehicles are constructed, but lays out some differences and rationale for we why use both.
Mutual Funds and ETF's are types of packaging and delivery vehicles for groups of individual securities and both allow simplistic access to multiple investment securities with one simple trade. Mutual Funds have been around since the 1920's and are much more common than ETF's which were invented and came to market in the 1990's. Mutual Funds and ETF's can be either Active or Passive, but generally, Mutual Funds tend to be Actively managed and ETF's tend to be Passively managed. The table below divides the 7,396 unique Mutual Funds (ignoring multiple Share Classes) and 2,407 ETF's that are currently sold in the U.S. today into Active and Passive buckets.
Source: Morningstar 9/2020
Generally, a "Benefit" for one type of vehicle can be considered weakness for the other, so we only list the Benefits here. Some of the Benefits listed below are applicable to the Mutual Fund vs ETF vehicle and some are the result of the strategy being Active or Passive. We ignored the characteristics of less popular Passive Mutual Funds and Active ETF's for this write-up.
Benefits of Passively managed ETF's
1) ETF’s tend to have much lower annual management fees than Active Mutual funds. When firms build and maintain a passive fund, they do not have to hire and pay a group of expensive researchers. They simply buy or build a rules based index that is primarily "managed" by an algorithm or computer. Cost savings are passed on to investors (in the majority of cases).
2) ETF's can be traded intra-day while Mutual Funds can only be bought and sold at the market close each day. Some investors value the flexibility of ETF trading because they know the price they will get by using a Limit order. You can't do that with Mutual Funds - if market prices goes up during the last moments the market is open, you will purchase a Mutual Fund at a higher price than you may have wanted. (Note that Huckstep Asset Management does not employ day-trading that relies on minute-by-minute price moves, so this benefit is not relatively important to us.)
3) Passive ETF's follow indexes that tend to be very diversified (they invest in a wide range of securities and have little weight on the largest holdings). They do not have the concentrated investment risk that comes with many Active Mutual Funds. In every Morningstar Category we have reviewed, at least one Actively managed Mutual Fund has produced worse performance during any calendar year than the worst Passively Managed ETF. Based on this track record, we feel we can safely say that Active funds are generally more risky than Passive funds.
4) ETF's exhibit low cash drag, resulting in better long term performance on average. Mutual Funds do not know if they could experience large redemptions during any particular day, so they usually keep some cash on hand to cover withdrawals. This cash underperforms stocks over the long run and has a detrimental impact on overall portfolio returns. ETF's do not need to hold extra cash in their portfolios like Mutual Funds do because redemptions of ETF’s are handled by market trades or the ETF redemption process.
5) Tax laws for ETF's are significantly more favorable to investors than tax laws for Mutual Funds. ETF’s can "wash" unrealized gains through the creation and redemption process. Taxable distributions that result from trading gains in Mutual Funds frequently result in lower after tax total returns for investors relative to an ETF with a similar investment strategy.
Benefits of Actively managed Mutual Funds
1) There is no bid-ask spread on Mutual Fund prices, as there is with ETF prices. All investors trade Mutual Funds at the same NAV (Net Asset Value) price each day when Mutual Fund trades are done, with no bid-ask spread return slippage. For ETF's with a wide bid-ask spread (typically unpopular, less traded ETF’s), investors can lose valuable return while trading. (Huckstep Asset Management watches spreads closely and only invests in ETF's with tight bid-ask spreads.)
2) Active Mutual Funds have the potential to produce positive Alpha, or extra returns, that are higher than a fund's benchmark. If the fiduciary that is picking your active funds has skill in identifying outperforming fund managers, this can help improve returns. (Note that this risk taking can also be a drawback, and can result in the negative Alpha, and if an investor’s nestegg is all invested in a small number of highly concentrated returns, the results can be disastrous.)
3) Mutual Funds are allowed to keep their holdings secret for a few months until they must be made public in regulatory filings, while ETF's must disclose their holdings constantly. This can be problematic for some ETF's, because cunning hedge fund managers or others may "front run" purchases or sales, resulting in less favorable pricing and lower returns for the owners of ETF's.
Although some advisors may elect to use only Active Mutual Funds or Passive ETF’s, we feel that there are benefits to both and that incorporating both in an investment program is prudent. In our Long Term Target Risk Strategic Asset Allocation Portfolios, we currently include nine Passive ETF's and four Active Mutual Funds. Our portfolios target allocations that sum up to roughly 2/3 Passive ETF's and 1/3 Active Mutual Funds primarily to keep costs down. When deciding where to use Active and where to use Passive, we consider that some asset classes that have historically exhibited relatively high volatility may offer the opportunity for fund managers to produce extra high Alphas by picking very high performing companies or simply avoiding the real duds. That is why we use active management for small cap equities and non-U.S. equities.