Mutual Funds For Grown Ups

Exchange Traded Funds (ETFs) are one of the most powerful investment products to hit the North American wealth management industry in recent years. No other investment allows all investors to use one product so effortlessly in managing both the long and short term.

With the rapid explosion in investor interest and media coverage, many have predicted the demise of the mutual fund. While this is obviously premature, ETFs will eventually surpass mutual funds in popularity.

An ETF is a single security that trades on a stock exchange, yet is composed of a basket of stocks. It is designed to track the performance of a specific stock market index, such as the TSX, the Fortune 500, or the S&P small cap 600. Other ETFs track specific sectors of industry such as energy or technology, specific regions or countries, or particular investment styles such as value, growth, or large or small capitalization companies, or bonds. There are currently about 1200 individual ETFs trading on North American exchanges in a huge host of asset classes.

For over 40 years evidence has been mounting that the large majority of mutual funds lag their benchmarks. The few funds that do outperform do so as a result of random chance. In the past three years only 12.5% of Canadian mutual funds beat the index they are measured against, and in the past 5 years only 7.5% of mutual funds beat the index. Some will ask that why do so many advisors cling to a value proposition that is contrary to the evidence? Are advisors aware that Nobel Laureates Harry Markowitz, Paul Samuelson and William Sharpe consistently recommend indexing over actively managed products and strategies? Are they aware that Warren Buffet has suggested that most investors are best served in pursuing an index strategy? Why does almost everyone in this business continue to wilfully ignore the inconvenient truth that the proposition of value-adding security selection is more likely than not an unattainable objective?

Asset allocation is a significant factor in achieving investment success since equity markets historically move in rotating cycles showing great disparity between hot and cold sectors of the market. ETFs are designed to be a core holding, a solid foundation, and their simplicity and flexibility can be used to easily snap together a portfolio covering the main components of a well-rounded diversified investment strategy. You can pinpoint sectors of the market experiencing strength and just as quickly reverse the position. Your portfolio can easily be weighted towards a portion of the market revealing strength, and just as quickly reversed. It is a low cost and liquid investment for those wishing to gain or reduce exposure.

There is a surprising lack of knowledge among seemingly sophisticated investors with respect to their investment choices. Most are unaware the management fee for a typical mutual fund, around 2.5 per cent, will eat up about 45 per cent of their retirement nest egg. Not so with ETFs, which charge a paltry fee of between 0.17 and 0.5 percent. Mutual fund investors pay what some would call extortionate management fees to fund managers who can’t pass the most basic tenet of their abilities, producing investment returns that match the relative index, and the few that do cannot be identified before the fact. Canadian investors have finally woken up to the fact that there are better ways to invest without paying the big fee.

Since ETFs trade on a stock exchange they can be bought on limit orders, sold short, margined, and options are available for hedging strategies. None of these attributes are available to mutual fund investors.

ETFs are passive investment as opposed to actively managed, meaning there is no fund manager making changes inside the portfolio. Stocks inside the ETF never change, except through mergers and acquisitions. While mutual funds are only required to reveal their holdings every six months, ETFs are transparent so you always know what’s in your portfolio. In constructing a properly diversified portfolio with mutual funds you have no idea what asset classes you hold, or their percentage of your over-all portfolio, since you don’t know the holdings of the funds you own.

The tax benefits are one of the ETFs most endearing qualities. When conventional mutual funds sell a stock, it generates a taxable distribution to unit holders. Low turnover means less tax. The ETF holdings never change, eliminating any taxable income, and the lack of a cash component in the ETF also eliminates any highly taxed interest distribution. ETFs have a mandate to be fully invested at all times.

Institutional investors use ETFs for issues such as cash equalization and risk or transition management, while individual investors can tailor their portfolio to their risk tolerance and then monitor, rebalance, and maintain long or short term focus.

They provide liquid cost-efficient exposure to a broad range of asset classes. ETFs appeal to the investor who has already created his or her wealth, or to the short-term trader.

Only a small portion of investors can maintain the discipline required for obtaining good portfolio management results. There is a tendency to over-trade their long term strategic asset allocation, chase performance, lose patience with stalling asset classes, and fail to monitor diversification and risk in their portfolios.

ETFs address all these concerns. Proper asset allocation boosts risk-adjusted returns with less volatility, and strategic rebalancing will guarantee an even higher combined return than already exhibited by these indexes.

Because ETfs do not carry standard commission or trailer fees, only fee based advisors and journalists will tell you about them. Commissioned planners will talk about independence but would never let you know ETFs existed. Fee based advisors charge clients a simple, transparent, sliding scale fee based on the amount of money being managed.

Core and Explore is an investment strategy where the bulk of your assets will be invested in a core of ETFs to provide diversification and steady growth at a low price. The other part of the portfolio will consist of growth vehicles, the explore part of the vehicle. Through traditional growth mutual funds or individual equities, or other ETFs, the explore section is meant to provide performance that is above the core of the portfolio.

There are also ETFs that increase in share price as the market declines. Yes, you can now buy a basket of securities that go up when the markets go down. Because of that, ETfs can now be used to hedge portfolios or as a tool when the markets slide.

ETFs provide considerable benefits over mutual funds, They are purer, more tax efficient, provide better returns, and are considerably cheaper. If you buy an ETF you’re just going to have to settle for beating the performance of hundreds of North America’s finest mutual fund managers.