After World War II, a new U.S. economy and the desire to put money away against another Great Depression drove the investing public to mutual funds. Today, more than 44% of U.S. households invest more than $11 trillion in the funds. Many of the 90 million people invested in mutual funds do so through employer retirement programs or a financial advisor pushing a specific family of funds.
Investors put money in mutual funds without question because well, because that's what everyone does, right?
The necessity and reasoning behind mutual fund investment may have made sense up to a few decades ago, but the stock market has changed and many investors have failed to change with it. The 7,600 mutual funds listed in the United States don't have a problem with this situation, but you should.
The truth is, mutual funds have largely become unnecessary and uncompetitive in relation to other investment tools such as exchange-traded funds (ETFs), which came about in the 1990s. ETFs basically fulfill the same need as mutual funds, but they allow people to invest money in a strategy without having to be exposed to risks from individual stock picking.
Investment in ETFs has reached more than $1 trillion, and should continue to take market share away from mutual funds in the coming years. This is because ETFs have five major advantages over mutual funds. Here they are...
1. Ease of trading and continuous pricing
Investors buy and sell an ETF just as they would any stock at any time of the day. Conversely, mutual funds are only traded at the end of the day, so investors don't know the trading price until the mutual fund manager calculates the value of securities in the fund for that day. This can be extremely frustrating, especially if the market trades significantly lower before the closing bell.
Mutual funds and ETFs charge an annual fee to cover administrative expenses, but these fees average a little more than 1% for mutual funds and 0.5% or less for ETFs. Many mutual funds also charge a front- or back-end fee called "load." The front-end fees usually cover commissions paid to sales staff or that financial advisor who was so enthusiastic about the fund, and can be as high as 5% of your initial investment. The back-end fee usually starts at around 5% of the initial investment, and then is gradually reduced depending on how long the fund is held.
Assuming a 1% annual expense ratio and 5% front-end load for the mutual fund, and a 0.2% expense ratio for the ETF with a 7% annualized return -- which has been the average adjusted return for the S&P 500 since 1950 -- an ETF investor with an initial investment of $100,000 would have $40,000 more after 15 years than a similar investment in a mutual fund.
Taxes can be a huge drag on your investment returns. They're also set to increase next year, depending on who wins the presidential race and in which tax bracket you report. While everyone owes their fair share to Uncle Sam, no one wants to pay more than they have to. And that is exactly what you may be doing with your mutual funds.
Because of the way mutual funds are structured -- as a pool of investments in which everyone has a share -- when someone sells shares, it may cause a taxable event for everyone regardless of whether they also sold shares. In addition, any year that the fund has more gains than losses on investments, all investors need to pay taxes on those gains whether they sold any shares or not. If the fund managers sell investments within a year of their purchase, then those taxes could be at the higher income rate.
Even worse, investors who bought into a fund at the end of the reporting year are responsible for taxes on gains made throughout the entire year. So if you just invested in the fund last month, that's too bad. You'll be paying for gains enjoyed by other investors for the previous nine months.
In the case of ETFs, because they trade like stocks, you control your own tax liabilities by deciding when to buy and sell the investment. The same investor in the example above would lose $45,000 during 15 years to a mutual fund with a tax drag just 1.2% higher than the comparable ETF.
4. Cash drag
Mutual funds may underperform similar investments because of "cash drag." Fund managers need to hold some cash aside to pay shareholders when they sell their shares. This cash sits in money-market accounts, making very little interest and pulls down the overall return of the fund.
Because it's possible to buy and sell ETFs directly from other investors, there is no need to keep this extra cash sitting around.
For investors who like to have a level of control over their portfolio, mutual funds may be hiding a big secret. Fund managers are only required to disclose their holdings on a quarterly basis. The practice of portfolio manipulation is so prevalent that it has even led to some market imbalances toward the end of the quarter. This so-called "window dressing" occurs when fund managers sell stocks that have dropped during the quarter, and buy winners misleading investors into thinking the manager had the right stocks in the fund all along.
ETFs on the other hand, must report their portfolio holdings each day.
Portfolio Value for ETF and Mutual Fund Investors
Some popular mutual funds and comparable ETF options
The PIMCO Total Return Fund (PRADX) is the largest mutual fund in the world. Managed by bond guru Bill Gross, the fund mostly invests in investment-grade bonds, but also takes positions in high-yielding foreign bonds. The fund has returned 8.5% annualized during a five-year period and charges an expense ratio of 0.85%. By comparison, the PIMCO Total Return ETF (NYSE: BOND) tracks the fund but charges an expense ratio of only 0.55%.
The American EuroPacific Growth Fund (AEGBX) invests in companies based in Europe and Asia, and seeks growth of capital. The fund charges an expense ratio of 0.84% as well as a sales charge of 5.8%. The WisdomTree Global ex-US Growth ETF (NYSE: DNL), on the other hand, charges an annual fee of just 0.6% and pays a 2.5% dividend. In each of the past five years, the ETF has gained an average of 1.6%, while the mutual fund has lost almost 4.5%.
The Fidelity Contra Fund (FCNTX) invests in stocks the advisor perceives to be undervalued, and holds domestic and foreign issues. It charges a 0.81% expense ratio and pays an insignificant 0.04% dividend yield. The PowerShares Dynamic Large Cap Value (NYSE: PWV) ETF charges an expense ratio of 0.59% and pays a dividend yield of nearly 2.5%. The fund has gained an annualized 3.1% during the past five years against returns of just 1.6% for the mutual fund.
The Growth of America Fund (AGRBX) invests in stocks and seeks to provide superior growth of capital. It charges a 1.47% expense ratio and may also charge a fee to buy and sell the fund. The Russell 1000 Growth (NYSE: IWF) charges an expense ratio of 0.2% and pays a 1% dividend yield. It has returned an annualized 2.2% during the past five years, while the mutual fund has actually lost 1% annually during the same period.
Risks to Consider: If you have held an investment in mutual fund for a long time, the taxes on a sale when you change to an ETF could be considerable. This should not matter much in the longer term, if the ETF outperforms or has lower fees. It will also not be an issue for tax-deferred retirement accounts.
Action to Take --> There really is no reason to favor mutual funds over ETF investing. For every investing strategy or portfolio using mutual funds, there is a comparable ETF that performs better and usually at a fraction of the cost and tax burden.