It's Time To Ditch Mutual Funds Once And For All

David Sterman's picture

Friday, January 2, 2015 - 12:00pm

by David Sterman

Merriam-Webster defines inertia as the "lack of movement or activity especially when movement or activity is wanted or needed."

Inertia explains why most investors still have a large chunk of their portfolios tied up in mutual funds. They were great investment vehicles in past decades, but they are no longer the best choice for investors.

Shake off that inertia, sell your mutual funds now, and re-deploy those funds into similar exchange-traded funds (ETFs). Years from now, you'll be very happy you did.

Another Subpar Year
Over the past decade, investors have grumbled that their mutual funds rarely seem to beat the broader market. And the past year really brought home that point. According to a recent report by Morningstar, 79% of mutual funds failed to beat their benchmarks (such as the S&P 500, Russell 2000, the CRB-Commodity index, etc.).

2014 "is likely to enter the record books as the year when active equity funds delivered their worst performance relative to the index, net of fees, since at least 1989," said Denys Glushkov, a research analyst with Wharton Research Data Services, in an interview with the Wall Street Journal.

Mutual funds' tepid returns aren't the biggest problem; instead, it is their tax inefficiency. A wide range of mutual funds reported taxable gains in 2014, even as many of them barely grew in value. That's because most major mutual funds have few big losers left in their portfolio, thanks to the extended bull market.

Without capital losses to offset gains, almost all portfolio changes have ended up triggering capital gains. (Of course this doesn't apply to funds owned in retirement accounts.) You can read about the capital gains impact of various funds in 2014 by visiting CapGainsValet.com.

Many of your peers have already begun to abandon mutual funds. Investors pulled a total of $71.5 billion out of domestic equity mutual funds in seven of the final eight months of 2014, according to the Investment Company Institute (ICI).

Where have those funds gone? Toward ETFs. Roughly $575 billion has been invested in ETFs over the five years ended September 2014, according to Morningstar. That roughly $115 billion annual inflow seems to correlate with a similar outflow now taking place among mutual funds.

Make no mistake; investors still have nearly five times as much money invested in mutual funds as they do in ETFs, but what was once a slow migration is now building speed.

How much speed? It took 18 years for ETFs to reach $1 trillion in assets, but only another four years to double the value of those assets to $2 trillion, according to ETF.com.

The real loser in all of this is the actively-managed mutual fund. Such funds typically have relatively high expenses to cover the cost of high-priced portfolio management teams.

Some funds avoid that burden by merely tracking an index.  That's the simple formula followed by Vanguard, which likely had its best year ever in terms of investor inflows.

On average, Vanguard funds carry a 0.15% expense ratio, less than one-tenth the fee of many firms' actively-managed funds.  The other charm of such index funds is that they have fixed portfolios and as a result, don't accidentally generate capital gains in excess of their actual returns.

What defines an index-based mutual fund and an ETF has surely blurred. The Vanguard S&P 500 index fund (NYSE: VOO), for example, is typically thought of as a mutual fund, but it's not. This fund, regardless of its classification, is a favorite of Warren Buffett and others, in large part due to its rock-bottom 0.05% annual expense ratio.

Vanguard charges a slightly higher 0.15% expense ratio for index funds that focus on a particular theme. The Vanguard S&P 500 Growth ETF (Nasdaq: VOOG), for example, invests in large companies with an above-average sales growth trajectory.

But investors need not solely focus on Vanguard, or index funds. A host of other ETFs offer low-cost investment themes as well, usually at one-third to one-half the expense ratio of a similar actively-managed mutual fund.

Let's use Asia as an example. The actively-managed Fidelity Emerging Asia Fund (Nasdaq: FSEAX) carries a 1.05% annual expense ratio and has delivered a 9.64% annualized gain over the past three years. The Vanguard FTSE Pacific ETF (NYSE: VPL) has delivered an identical three-year return, yet with an expense ratio of just 0.12%.

Risks To Consider: Not all ETFs are well-constructed. Focus on funds with high trading volumes, expense ratios below 0.75% (and preferably much lower than that) and minimal portfolio turnover.

Action To Take --> This is a good time to examine the performance and fee structure of mutual funds in your portfolio. Compare them to similarly-focused ETFs. If your active fund manager is able to beat his or her benchmarks to a degree that more than offsets the higher expenses, then stick with that fund. If not, then it's time to ditch the mutual fund -- and its tax inefficiencies and high expenses -- and migrate the funds to ETFs.

Though Vanguard remains a fund favorite, investors may also want to give a fresh look at Fidelity's ETF offerings. The fund company ignored this investment category for too long, but has recently rolled out a range of ultra-cheap ETFs that mirror the focus -- without the high cost -- of many Fidelity mutual funds. As an example, the Fidelity Select Technology Portfolio mutual fund (Nasdaq: FSPTX) carries a 0.77% expense ratio while the Fidelity MSCI Information Tech ETF (Nasdaq: FTEC) has a 0.12% expense ratio.

Other mutual fund firms are seeking to beef up exposure to ETFs as well. Mainstay Funds, for example, which is a division of New York Life, recently announced plans to acquire ETF provider Index IQ. If you can't beat 'em, join 'em.

One of the best ways to an investment that is going to outperform -- whether it's a small-cap, blue chip or ETF -- is to look at its momentum. Academic studies have shown that this is one of the only indicators that has consistently outperformed the market. In fact, two of my colleagues have been quietly testing the Maximum Profit system, which is making a small group of investors a lot of money. It flags exactly which stocks are about to jump double, even triple digits in the coming days, weeks and months. And it recently tagged a few more stocks that could do the same. After nearly two years of beta-testing they are finally revealing this system. To learn more, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.