By: Larry MacDonald

Here is the second part of the post on the ETF vs. mutual fund debate ….

Product integrity

The ETF vs. mutual-fund debate often overlooks important side issues, notably the stability of the products. After an investor purchases a mutual fund or ETF, it may change in various ways. But the changes for ETFs appear to be on a much smaller scale compared to mutual funds. Examples of the changes affecting mutual funds  include:

• turnover in portfolio managers – many investors may buy into a fund because of a well-regarded manager only to see the star later jump ship for another fund, leaving unitholders faced with the decision to stay with a less skilled manager or redeem and pay a rear-end load fee as high as 5%

• changes in the manager’s investing style (style drift) – portfolio managers may stay put but then start trying investment approaches different from what unitholders expected, increasing, for example, the proportion of risky securities in an attempt to juice returns

• termination or merging of a fund with another fund – which again presents unitholders with a disruption in their investing plans

Tax efficiency

While some ETFs may distribute taxable capital gains to unitholders, the incidences are more the exception to rule. Mutual funds, on the other hand, tend to distribute capital gains as a rule rather than the exception. At least that is what the averages would seem to indicate: for example, David Swensen’s book Unconventional Success shows that the average annual distribution of S&P 500 index mutual funds was 1.8% of assets from 1993 to 2002, compared to 0.01% for the SPDR S&P 500 (SPY)

Flexibility

The more one can tailor an investment vehicle to their needs, the more one can maximize their utility; having extra options is a valuable trait to many investors. Some examples:

• ETFs can be bought and sold at a known price throughout the trading day while mutual funds are bought and sold at the price prevailing at the end of the day.

• ETFs can be purchased on margin, sold short, and combined with ETF options to create covered trades and other hedging strategies

Diversification

Mutual-fund defenders say Canadian equity ETFs i) expose investors to the risk of stocks growing to a large weighting in the index, (Nortel effect) and in the case of Canadian broad-market indexes, ii) leave investors weighted toward financial and resource stocks. Let’s deal with these two points in turn:

• as for the “Nortel effect,” Canadian ETFs are no longer exposed to such risk; the fundamental ETFs offered by Claymore in Canada are not market-cap weighted and ETF families using market-cap weighting now limit the weights of individual stocks so that none can have the influence Nortel once had.

• as for achieving a portfolio less weighted toward energy and financial stocks, that would seem to be an asset allocation choice perhaps better left to the individual investor (they can tailor exposures to their preferences better than an equity mutual fund can); ETF investors typically achieve their desired level of diversification through holding a portfolio of ETFs tracking a variety of asset classes such as small caps, U.S. stocks, and international stocks.

Performance

Mutual fund apologists say mutual funds: i) offer the potential to outperform the market, ii) show periods of outperformance, and iii) have relatively better performance in sectors like small caps and U.S. stocks. Let’s deal with these three points in turn.

• as for the potential to outperform indexes, some mutual funds may be able to do so (studies show less than 5% over the long run) — but identifying them ahead of time is hit and miss; odds are that the investor will end up an underperforming fund

• as for periods of outperformance, using more extensive time sampling and adjustments for survivorship and other biases, virtually all mutual-fund-performance studies published in peer-reviewed journals indicate “that mutual fund managers on average underperform their risk-adjusted benchmarks,” to quote Professor Richard Deaves in his book, What Kind of Investor are You? (Deaves own study of the Canadian stock market found that equity mutual funds on average fell short of their indexes by more than 1% a year over the period 1988 to 1998)

• as for relatively better performance in sectors like small caps and U.S. stocks, the odds of picking an outperforming fund may be higher but then again, it is hard to identify ahead of time which funds will do so (or at least avoid management changes, style drift, closure, etc.)