Open-end mutual funds and exchange traded funds (ETFs) are the two most common ways to invest in passive index funds. How are they similar in investment characteristics? How do they differ for investors?
“What are trading considerations with ETFs and mutual funds?”
ETFs trade on public exchanges. You can buy or sell at any time in the trading day. Open-end mutual funds, as opposed to closed-end funds which we will not include in this discussion, are bought and sold directly with the fund company. With the majority of funds, being tradable at close of day net asset value.
If you are an active trader, who wants to jump in and out of investments, the ability to continuously trade may make ETFs more attractive. For most long-term investors though, this is not an issue.
“What about liquidity?”
ETFs can be traded continuously, whereas mutual funds can only be liquidated in set time periods. Often, end of day valuations. But in some funds, less frequently.
So ETFs are more liquid.
Or not.
If you own an ETF that is thinly traded or has little market capitalization, it may be difficult to find a buyer or seller to trade with. The harder it is, the greater the bid-ask price spreads, which impact asset liquidity.
Whereas, unless your fund company is insolvent, you always have a ready partner to buy or sell mutual fund units.
It is prudent to invest in ETFs with significant assets under instrument, that trade on established stock exchanges. With mutual funds, consider fund companies that are well established, with strong finances.
“What about transaction costs? Sales commissions, brokerage fees, and so on?”
ETFs are traded on stock exchanges. Usually there will be a brokerage commission charged on each trade. Today, that may be under $10 per transaction, regardless of the volume. Of course, that is through an online broker, not a full-service one. So shop around when deciding on the brokerage house to use.
Some brokers offer certain “no-transaction fee” ETFs, where the trading costs are waived. Not an extensive list. Often not “best of class” ETFs. But something to consider when weighing which ETF to purchase.
Mutual funds do not incur brokerage fees. But you may be charged a sales commission, or load, when buying or selling a fund.
Research data indicates that sales commission funds do not provide superior performance over no-load funds. And that is definitely true for simple, index funds. Unless you plan to invest in some extreme-niche index, never pay a load for an index fund.
“Taxes are another cost. How do ETFs and mutual funds compare on tax efficiency?”
Tax treatment varies on a jurisdiction by jurisdiction basis.
Often, ETFs offer better tax efficiency. But investors should consider their own tax jurisdiction and personal situation. Then factor that into the cost analysis.
“What about Management Expense Ratios (MERs) differences in mutual funds and ETFs?”
ETFs, on average and over time, have enjoyed lower MERs.
But that can be a tad misleading. Historically, mutual funds tended to be actively managed. ETFs were more passive. One would expect a cost gap given the lack of management fees in the passive ETFs.
But even comparing apples to apples, ETFs still tend to maintain a cost advantage. Not always. And there are other factors that come into play. Economies of scale being the big one.
Do not automatically assume that ETFs will be less expensive. Within an asset class or subclass, assess across all passive investments in comparing net performance and cost structure.
What are mutual fund “shenanigans”? Factors that can distort your ability to properly review and assess a mutual fund’s investment performance. Including: intentional or accidental actions by fund managers; survivorship or creation bias; portfolio style drift; window dressing.
“How can the fund managers affect my ability to assess fund performance?”
In a few ways. Some may be intentional by fund management. Or simply accidental.
If you are analyzing results from the last 5 or 10 years, who generated those returns? Current management? Or was the current team only brought on in the last 3 years? That can be bad if a superior group of asset managers left. But it may be good if a new unit was hired to replace underperformers. In either instance, difficult to attribute longer term performance to a team that did not create the results.
Perhaps the 5 to 10 year performance was all during one type of market. A bull market, where everyone does well. How will the management team perform in volatile conditions or a bear market? Usually useful to assess how managers perform in different market conditions.
Maybe the fund’s managers are “index huggers”. Where the portfolio holdings highly reflect the underlying benchmark index. Yet, as an investor, you pay a management fee for active management. In a relatively small equity market, such as Canada, many large mutual funds may become index huggers by default. Not the manager’s fault. More a reflection of having very limited investment options for very large assets under management. But why pay for that management if you are not getting it?
“What is survivorship bias? How can it impact my performance analysis?”
Underperforming mutual funds may close down. A few reasons why this might occur. The main one being that if you have 10 investment options and one is consistently in the bottom 10%, would you invest in it? If you already owned the fund and saw that it was in the bottom 10% over time, would you stick with it?
The answer to both is (hopefully) no. The fund will not attract new investment capital. Assets already in the fund will diminish as investors sell and move their proceeds elsewhere. With less assets, fund expenses are spread over fewer investors, resulting in higher management expense ratios. Which further dissuades new investors from coming in. At some point, the fund is no longer feasible and is shut.
The problem is that once a fund is closed, it may no longer be included in peer performance calculations. That distorts average returns for the investment category. As well as fund ranking within that category.
There are 10 funds in a category. Your fund is ranked fifth, right in the middle. Not great, but perhaps tolerable. Suddenly, the three lowest ranked funds close. Your fund now sits in the bottom third. Same fund. Same absolute performance. Yet it goes from right in the middle of the pack to nearer the bottom.
To a lesser extent, similar issues may arise with creation bias.
“What is style drift? How can it create fund shenanigans?”
Mutual funds are usually aggregated by investment category and/or style. US small-cap equities. Canadian investment grade corporate bonds. Australian mining sector.
Within a specific style, there tends to be an equal risk-return profile and similar investment universe. Asset managers operate under a somewhat level playing field when choosing portfolio holdings.
Style drift occurs when an asset manager deviates from the stated style. Perhaps taking on added risk, hoping to earn higher returns. The wider the drift, the less comparable performance is between funds in the same category.
A problem for investors in assessing and in the risk they may unknowingly have in their own portfolios.
“What is window dressing all about? Sounds like the store front in my local mall.”
Window dressing is pretty much that. Just before a reporting deadline, fund managers try to make their portfolios more attractive. In the hope that an investor “walking” by, might stop, be impressed, and come in for a purchase.
Window dressing may hide bad investment decisions. Yes, the performance is reflected in the annual results. But when a potential investor reviews year end portfolio holdings, he/she sees Apple, Amazon, Tesla. Not Blockbuster, Kodak, or Enron. That may influence their view of the manager’s skill.
Window dressing can also hide index hugging and style drift.
A fair bit of information covered. However, if you intend to review mutual fund performance, it is useful to understand how the results may be distorted. Always be on guard for potential “shenanigans”.
How to properly assess a mutual fund’s performance? First, compare investment returns on an absolute basis. Then, on a relative basis versus historic results, risk-adjusted returns, fund peers, and customized index benchmarks.
Yes, investment returns should also be compared against benchmarks. By comparing actual results against different variables, it helps ensure that you cover all angles in your analysis.
You can compare actual return versus the fund’s historic results. Are there trends or changes from past performance? What has led to any variances? New fund management? Good (or bad) investment strategies or tactics? Fund costs?
You can analyze fund results on a risk-adjusted basis. Comparing against zero, real, and risk-free rates of return. Or factoring in risk-adjusted return ratios, such as Sharpe, Sortino, and Treynor ratios.
You can assess the fund versus its peers. How does the fund ranks in its investment category (e.g., Canadian bonds, US small-cap, consumer discretionary equities)?
Finally, benchmarks can be created to assess performance. With over 3 million indices available, investors can easily develop bespoke benchmarks to assess investment funds and portfolios.
As you can see, there are many ways to assess a mutual fund’s investment results. On its own, as well as against relevant benchmarks. For additional information on this topic, please refer to “Mutual Funds: Performance” and “Mutual Funds: Performance is Relative”.
A potential disadvantage of mutual funds for investors may be the fund costs. A possible sales commission, or load, when buying or selling. Plus the ongoing management expense ratio charged to the mutual fund. These costs can significantly impact mutual fund performance. And investor wealth accumulation over time.
The “load” is the sales commission that may be charged when buying and/or selling a mutual fund (or other investment product).
Loads, or commissions, may come in a variety of forms. Front, back, or declining, are three common examples. We review the similarities and differences between these different types. And when one may make better sense for your own requirements.
“Are there any no-load funds?”
Not paying a sales commission to buy (or sell) a mutual fund seems like the smart move. There are many funds that do not charge loads when buying or selling the investment.
However, there are issues to watch out for when investing in no-load funds. The key one tends to be that the ongoing annual expense charges in the fund may differ between load and no-load offerings.
“How does ‘no-load’ differ from ‘no-transaction fee’ costs?”
No-load means you do not pay a sales commission when buying or selling. That commission would have been paid to the fund company.
No-transaction fee refers to the trading cost charged by the broker you use to buy or sell. Normally, investors trade directly through the fund company. With no transaction fees charged, only commissions.
Increasingly, banks and online brokers have developed relationships with certain fund companies. Allowing their clients to access mutual funds via the brokerage, rather than having to set up a new relationship with the fund company.
“What is a mutual fund’s ‘Management Expense Ratio’?”
The Management Expense Ratio (MER) is a separate cost from a sales commission.
The MER covers the ongoing costs of operating a mutual fund. Administration, marketing, trading.
The largest cost tends to be the fund management fees. For actively managed mutual funds, this will be the main component of the MER. For index funds, this should be zero.
There may also be continuous retrocessions, or “trailer-fees”, embedded in the MER. These are often paid to the fund salesperson who sold you the investment product.
What, you thought that “free” financial advice was free?
“How does this all work in the real world?”
We take a look at one the larger Canadian equity mutual funds.
How loads work. How they differ. How MER can vary between fund’s different share classes.
“What do most investors buy? Front, back, declining, or no-load funds?”
Over time, there has been clear trends in mutual fund investor buying patterns. In many areas.
As far as loads, the shift over time has been to no-load products from load products.
“Can you explain more on MERs? What does the data tell us on costs and investor trends?”
We review actual data on typical mutual fund costs.
Particularly, how MERs tend to correlate to the specific type of investment. In general, the more complex the fund, the higher the MER.
We also look at investor trends in seeking out lower cost mutual funds. Why this is the case.
“What lessons can I learn from mutual fund costs and investor behavior?”
There are many great lessons to learn from what is happening in the real world.
I think this point is important. Theory is great. But the key is seeing the empirical evidence.
I may tell you that investment costs are a key predictor of future fund success. That active asset managers do not beat their benchmarks on a consistent basis over time. Therefore, cost minimization is crucial to investing success. It sounds good. Makes sense to me.
But what about the real world, not the land of theory? Here, we can see that investors are making that shift based on the actual data. Not in a lemming or investment bubble crazed manner. In a consistent change over time as the lessons of low cost investing sink in.
This will be a focus moving forward. Why you should consider low-cost investments for your portfolio?
What are the perceived advantages in using mutual funds to create a well-diversified investment portfolio? Fund companies usually claim: easy diversification; painless investing; high liquidity; low-cost; professional asset management. A look at these potential advantages of investing in mutual funds.
“How can mutual funds provide my portfolio with ‘easy’ diversification?”
There are a vast number of mutual funds, covering almost every asset class and subclass. And every style or type of investing you desire.
Many mutual funds are well-diversified within their asset class or subclass.
If you want total ease, there are balanced or target date mutual funds that may allow you to invest all your capital in one, single investment. Investing cannot be more simple than that.
Mutual funds may provide access to investments that smaller investors cannot access on their own.
Perhaps you want venture capital in your portfolio. You may require a significant cash investment to access some venture capital investments. Many of which may have relatively poor liquidity and necessitate a 12-14 year investment period. Factors that may exclude a venture capital investment for many smaller investors. However, a venture capital fund may allow for smaller capital contributions and more consistent cash flows. Making this more attractive for smaller contributors.
“Why is investing in mutual funds considered ‘painless’?”
Mutual funds can be very cost-effective and efficient to buy and sell.
Initial purchases tend to have reasonable minimums. Subsequent investments are often at even lower dollar amounts. As well, there are normally direct deposit systems and dividend reinvestment plans. Both of which facilitate future purchase patterns.
Fund companies track and disclose fund holdings and performance on a continuous basis. Allowing for investors to easily monitor their investments. Fund companies also produce tax data which simplifies the investor’s personal tax preparation at year end.
Painless investing is indeed a big selling point for mutual funds. And a large differentiating factor between fund companies in trying to attract new investors. So, yes, mutual fund investing tends to be simple and straightforward.
“How can mutual funds help improve investor ‘liquidity’?”
Common mutual funds can normally be bought and sold on a daily basis. Based on the fund portfolio’s closing net-asset-value. This results in decent liquidity within larger, more established mutual funds. And for investors with relatively low amounts of money in a specific fund.
Note that some mutual funds may allow for purchases and redemptions on a lesser basis. The less frequent the ability to trade, the more likely you will face liquidity concerns.
“Why are mutual funds considered ‘low-cost’ investments?”
Attempting proper diversification via individual, non-diversified assets is typically neither “easy” nor “painless”. It also tends to be relatively expensive.
In transaction costs, to buy or sell multiple investments. In paperwork cost, to monitor the portfolio and deal with tax details. Or, in fees to delegate your portfolio management and accounting to a professional.
Also, in opportunity cost. The commitment required to monitor and maintain the investment portfolio if you do it all yourself. When there may be better uses of your valuable time. That, too, is a cost.
Mutual funds can provide cost-effective diversification. Especially for those with less capital.
Fund companies pool many investors’ funds to spread out investments and risk. Large funds enjoy economies of scale to widely disperse ongoing expenses. Both of these benefit the individual investor.
“Having my money managed by professionals is obviously an advantage, right?”
The same concept holds true for professional asset management within a fund.
By spreading out the portfolio management fees over a wide number of investors, the fund can hire competent asset managers to improve fund performance.
Or so it goes in theory. Having an investment expert make portfolio decisions should be better than non-professionals, such as most people reading this or watching the video.
However, when we drill deeper into mutual funds, professional asset management may not always be the advantage that it seems to be. Yes, a bit of foreshadowing there.