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.
Over the last few sessions, we compared active asset management with a passive investing strategy. There are many reasons why passive investing may be preferable for most individual investors. If you are going to passively invest, then what type of investments should you purchase? Suitable investments tend to be low-cost, index mutual or exchange traded funds.
“Are all mutual funds actively managed? Are there any passive index funds?”
Yes, there is an increasing quantity of passive index mutual funds on offer. In large part driven by the fact that investors are realizing that passive management tends to be the better strategy.
If you wish to invest via a fund company, you should be able to find passive index funds across a wide swathe of asset classes and subclasses.
“Should I pay a sales commission when buying an index mutual fund?”
No.
There are so many index mutual and exchange traded funds (ETFs) available, that it is hard to think of a situation where paying a front/back/declining load is warranted.
Passive investing is about minimizing costs. Paying commissions to purchase funds runs contrary to that.
“What about Management Expense Ratios (MERs)?”
As with loads, you want to minimize costs.
Studies show that low cost is a major predictor of future performance success.
When buying the index, look for the lowest cost funds. That said, there is more to a fund’s “cost” than just loads and MERs. There is also the cost of poor fund construction. The tracking error that results between the fund returns and the benchmark return. If your fund is lowest cost because it saves money with weak replication of the benchmark in the fund, that also needs to be assessed as a cost.
“How do ETFs compare with open and closed-end mutual funds or common shares?”
I tend to like ETFs over mutual funds. But that may be more due to living in Western Canada.
Historically, Canada has “enjoyed” some of the highest mutual fund fees in the developed world. Also, the mutual fund market was relatively small in Canada versus other developed countries. Add in the growing number of high-quality, low-cost ETFs introduced in Canada over the last decade or so, and ETFs usually are the best passive funds where I work. Your own experience may differ.
In the last few episodes, we have reviewed active asset management. Unsurprisingly, passive investing takes the opposite approach to active. So what are the keys to passive investment management? Match the market return. Minimize portfolio costs. Target asset allocation to investor profile.
In passive investment management, the goal is to match the market return. Unlike active management, where investors want to outperform the passive benchmark on a net return basis.
The three keys to replicating market returns are minimizing portfolio tracking error, transaction timing, and operational costs.
The market benchmark has no cost and trades instantaneously. As a result, investors will never perfectly mirror the market return. But by focussing on these three areas, one can minimize the variance.
“What should I watch in minimizing portfolio costs?”
Portfolio costs reduce net return and impair the ability to match market returns.
This is a big reason why active asset management seldom outperforms. If an investment fund has a Management Expense Ratio (MER) of 1.5% and the benchmark return is 7%, that requires significant skill to achieve manager alpha.
The MER is a hard cost. You can readily identify it in a fund. If you are simply investing in a benchmark, then lower costs tend to be better.
However, there may be a tradeoff between things like tracking error and MER. That is why it needs to be assessed in conjunction with returns.
That said, fund costs tends to be the biggest predictor of future success. So focus on keeping costs low.
It is relatively easy to identify individual low-cost index funds that closely match market performance.
The more difficult part is to find the correct funds in the right asset classes and subclasses. Then, hold the investments in the appropriate percentages.
Investments need to fit into the overall target asset allocation. The one you should create based on your unique investor profile. That factors in your financial situation and expectations, investment objectives, personal constraints, time horizon, and risk tolerance.
Investing based on your investor profile and target asset allocation is crucial for long-term wealth accumulation. The optimal asset allocation tends to be more important to investing success than the specific assets purchased. In fact, many studies show that the target asset allocation accounts for over 90% of the portfolio’s variability of returns.
Very important to get this part correct. Focus initially on your target asset allocation. Then fill it out with low-cost index funds in each category.
Individual investors often omit or undervalue this part of the process. Instead, they fixate on the actual investments and build their asset allocation from the ground up. A function of the investments. Rather that the target asset allocation driving the investments.
Why is active asset management typically not a good strategy for investors? Previously, we discussed a few factors. Sales commissions. Active management costs. Inability to time market movements. Efficient markets make it difficult to consistently pick the “best” investments.
But what does actual investor behaviour tell us about active investing? How are investors dealing with the active versus passive management debate? What lessons can you take away for your own portfolio?
In Episode 36, we saw that the some research studies believe active management can beat passive. While other studies find the reverse. That passive management is the best approach.
In Episode 38, we take a look at what investors are doing. How their investing patterns are changing over time. That may provide some real world information that helps in your decision-making.
“If active managers cannot outperform, why do investors continue to pay sales commissions?”
Good question. If a specific investment fund, or other asset, cannot achieve alpha – outperformance of its passive index benchmark – why do investors readily pay a load (sales commission) just to buy the asset?
The reality is they are not.
In the past, a lack of investor education and strong investment company propaganda (marketing) led investors to believe they should pay for the privilege of owning a fund.
As well, the belief that the cost of purchasing was related to the “free” investment advice received.
We see in the data that investors are continuing to move into no-load funds. Is it just great marketing from no-load fund companies? Or perhaps investors are simply tired of paying for nothing.
“What does the data say about ongoing fund costs?”
We have discussed how Management Expense Ratios (MER) are a significant drag on fund performance.
What are typical levels of MERs in funds and fund asset classes?
As we have covered, we see that MERs indeed do tend to correlate to the specific asset class and the work required to manage the fund. The more simple markets tend to have relatively lower costs than the smaller, more complex markets. If you intend to invest in market niches and/or inefficient markets, as we considered in Episode 37, you may end up paying higher costs.
We also see a tightening off fees over time between funds. This makes sense as we have discussed how investment costs are a large predictor of fund success. Also, with increased competition for investor capital, funds need to compete on prices to a greater extent than they did 20 years ago. This is even more true, given that they cannot promote outperformance to potential investors.
“What about the MER differences between index and active management?”
Again, we see the data reflect the points previously discussed.
In 2019, MERs for actively managed equity and bond funds averaged 0.74% and 0.56% respectively.
In 2019, MERs for index equity and bond funds averaged 0.07%.
If a realistic return expectation is 6-8% per annum for a portfolio, the active managers need to do very well to compensate for the higher annual costs.
“What does the data say about market timing?”
It is hard to believe that professionals have difficulty timing market movements. A large part of the problem is that getting it wrong, even for just a few days, may greatly distort long-term returns.
For example, you invest $10,000 in the S&P 500 on January 1, 1980. If you took a buy and hold approach, on December 31, 2018 the portfolio was worth $659,515.
However, if you decided to market time, results may be different. Had you just missed out on the 5 best days of the entire 13,870, your portfolio would have fallen to $426,993. A 35% decrease.
If you missed the 30 best days, your portfolio would be worth $125,080. An 81% decrease.
And yes, perhaps if you had timed the declines, you may have been compensated. But it is very interesting how missing out on a few very good days over 18 years has such impact on growth.
Also, look back on the last 20 years or so. After the 9-11 crash. The 2008 financial crisis. The 2016 Trump election. The COVID bull run. Listening to the talking heads on television or assessing on your own, would you have reinvested exactly at the bottom, right as the market started upwards again?
Some good investment lessons to be found in this session. If you wish to read a little more on this topic, please refer to, “Why Active Investing is not Optimal”.
Should you actively invest? Directly, trading in your own investment portfolio? Or indirectly, utilizing a professional active asset manager, like a mutual fund manager? Or mix and match between active and passive investing, based on the specific market or asset?
However, there two areas where active management can outperform.
Ignored and/or inefficient markets. And niche markets or sectors.
“What do you mean by ignored or inefficient markets?”
Inefficient markets are those where security prices do not reflect all available information.
Perhaps a market with poor regulations and oversight. Maybe smaller markets that are not followed extensively by analysts and investors. “Over the Counter” (OTC) securities that are thinly traded. Or private companies, where there may be no market at all.
Market size may cause it be ignored. A mutual fund with $2 billion in assets may not be able to invest in certain markets or securities. For example, due to regulations like the “75-5-10” rule discussed below.
“And niche markets or sectors?”
Often, similar issues as with inefficient or ignored markets. With less attention and scope, niche areas may fall off the investment community’s radar. Less analysis and focus, more opportunity for pricing inefficiencies. And the chance for knowledgeable, active traders to profit.
The other aspect of niche sectors relates to the individual investor. If you have expertise in a business or sector, that may also create a competitive advantage to be exploited.
In my case, I have an oil and gas background, especially with junior companies in Western Canada. I may have a competitive advantage investing in these companies over someone who lacks that experience.
One of my fellow Board members on the CFA Society Saskatchewan holds a Masters in Cyber Security. His knowledge in this sector is extremely strong. I would not like to compete with him for the “best” investments in this niche.
When I worked at UBS, I was friendly with the team that advised clients on fine art holdings. An investment very common in trusts. Fine art is an extreme niche. Where the greater the expertise, the better the results. I would never want to value a rare painting. I would defer to the experts.
If you possess expertise in a niche, that may give you a competitive advantage in that area.
“What is the ’75-5-10′ rule?”
As mentioned above, rules and realities can make it difficult for larger investors to access certain niche or neglected markets. That may result in ignored sectors.
We close the episode by looking at actual investments. Vietnam based Dragon Capital? Indonesia’s Kinjer Pay. Saskatchewan’s Grow Solutions. Fidelity’s International Small-Cap Equity fund.
And see that even if large investors wish to invest in a niche area, it may not be feasible. Again, less competition may create positive opportunities for smaller investors.
If you plan to invest in inefficient, ignored, or niche markets, then active strategies may generate positive returns to benchmarks. However, it does take extra work in these markets. And there may be additional costs to research and trade in less efficient sectors. That may impact your overall performance.