Mutual funds and ETFs are two of the most common investment vehicles for individual investors.
That’s a good thing—and there are several reasons why.
Mutual funds and ETFs can both provide diversification at a low cost, which we believe is essential to a sound long-term investment plan.
Mutual funds and ETFs, while similar, are not the same. Let’s explore each vehicle and see how their differences can impact you.
A Look Into ETFs
Let’s start by taking a deeper look into ETFs.
An ETF is a collection of individual securities such as stocks or bonds that you can buy in one package. More often than not, ETFs passively track a market index such as the S&P 500.
For nearly every market slice or segment, there is an ETF that tracks it. An ETF’s accuracy of tracking of it’s underlying benchmark can be determined by its R-squared. R-squared measures the variance in the funds’ price movements compared to its benchmarks price movements. Typically, passive funds which seek to track a benchmark have very high R-squared – meaning it’s tracking its benchmark closely. Whereas active funds typically tend to have lower R-squared as they don’t closely track the benchmark index.
Because of the wide availability of index ETFs, you can create an entire portfolio of passive ETFs for any asset allocation you need.
Doing so has a significant impact on your investment performance. Research shows that the majority of actively managed funds fail to beat their benchmarks over extended periods of time.
Since passive ETFs replicate the benchmark, you don’t have that issue. Be aware, though, that not all ETFs are passively managed. As Wall Street catches on to the operational benefits of ETFs (like the added tax efficiency), more actively managed ETFs are also popping up.
How ETFs Differ From Mutual Funds
Mutual funds and ETFs are quite similar on the surface. Both are a basket of securities that provide investors greater reach to broad market segments. But there are some critical differences.
1. ETFs are more transparent and liquid. The name Exchange-Traded Fund means precisely that. ETFs trade on the exchange with continuously adjusting prices just like a stock, so you always know what your investment is worth. Mutual funds don’t trade but are “redeemed” only once per day after the market closes and the fund’s net asset value has been established.
2. ETFs are more tax-efficient. You can control when you buy and sell shares to plan around realizing your capital gains. ETFs are also more tax-efficient than mutual funds because of the way mutual funds pass on gains and losses to shareholders.
Unlike ETFs, mutual funds have embedded gains and losses that get passed on to shareholders at the end of the year. If you buy a mutual fund with an embedded gain, then a portion of that will get passed to you, even if you bought into the fund after the gain was realized. Mutual funds create embedded gains when the fund managers sell individual fund holdings for a profit.
What’s more, you can even receive a capital gain distribution if the value of your investment falls because the fund declined after you bought it!
That’s exactly what happened to many investors in 2008. Some individuals realized losses of 45% and higher but still received a Form 1099 with capital gains that they had to pay taxes on.
How did this happen?
The reason was that many other investors had sold their mutual fund shares in 2008, so the fund managers had to sell shares of the individual stocks held by the fund to raise liquidity for the redeeming shareholders.
3. ETFs tend to be more affordable. Largely due to their passive management nature and operational efficiency, ETFs tend to have much lower expense ratios. It is increasingly common to find ETFs with expense ratios below 10 basis points for the major indexes. Because many brokerage firms now offer commission-free equity trading, you can even buy them for no transaction cost.
4. ETFs typically give you access to a broader array of securities. Many mutual funds only invest in a select few securities based on their chosen strategy. ETFs offer more varied exposure and greater diversification.
Where Active and Passive Investment Strategies Collide
Most mutual funds are actively managed, which just means that fund managers hand-select investments. This strategy can be more expensive because you pay for their time, they engage in more trades (equating to higher turnover), trigger more taxes (due to high turnover), and bring additional risk (typically, due to lack of diversification). While short-term picks might make sense for a limited time, the likelihood of sustained long-term success is slim.
Passive investing follows an underlying index like the S&P 500, Russell 2000, or MSCI EAFE, decreasing investment, management, and trading fees. Passive investing is also more focused on long-term strategy as opposed to short-term sprints.
Generally, mutual fund managers make concentrated bets on a smaller number of securities as their goal is to pick stocks that will beat their given benchmark index. Whereas an index fund is more broadly diversified in terms of the number of securities held. As previously mentioned, decreased diversification through the number of securities in a fund historically leads to underperformance.
There’s significant evidence to support that claim. Hendrik Bessembinder, a professor from Arizona State University, researched buy-and-hold returns using the Center for Research in Security Price (CRSP) database of approximately 26,000 securities.
His research showed that when stated in terms of lifetime dollar wealth creation, 58% of stocks failed to beat the Treasury bill returns over their lives. Looking at those stocks that beat Treasury bills, only 38% of those stocks returned moderate amounts. Finally, his research pointed out that just over 4% of stocks are responsible for boosting the market’s overall returns higher than those of Treasury bills (0.38%).
Relying on active management to outperform an index is the equivalent of risking your entire return on identifying the 4% of stocks that are going to carry the market. Those aren’t betting odds!
At Blue Rock, we believe the keys to a successful investment strategy are grounded in the idea that markets are efficient, low-cost and tax-efficient investment vehicles, broad diversification, and systematic rebalancing provide the greatest chance of success for disciplined investors. Call us today to see how we can apply these principles to help you accomplish your goals.