Tuesday, February 7, 2012

The Great Debate: ETFs vs. Mutual Funds

    One of the most heated debates amongst individual investors is that which pits managed mutual funds vs. ETFs.  I speak from experience.  In the past I wrote a piece which dared to asked, “Which are better?”  The comments that followed resembled a heated exchange one may witness between Yankees and Red Sox fans.  For the record, “Let’s Go Yankees!”  Where was I?  Ah yes, the topic of managed  mutual funds vs. ETFs.  I feel I am qualified to discuss the topic without prejudice.  I own both ETFs and managed mutual funds.  I have also designed long-term successful portfolio strategies using both, and the return results can be found daily at www.allocationforlife.com.
    Many individual investors feel strongly for or against both mutual funds and ETFs.  However, the fact is there really is no correct answer as to which is a better investment choice.  In my experience I have found that a performance edge can be found for both based on current market conditions.  When looked at as a whole, ETFs tend to outperform the average mutual fund in periods of flat market movements or in times when the market seems to be moving straight up.  Managed mutual funds have a tendency of outperforming ETFs when the markets move aggressively lower and volatility is very high.  For example, let’s look at an allocation I use for both a managed mutual fund portfolio and an ETF portfolio.  The allocation is exactly the same for both models and the returns are as follows and as of February 6, 2012:
    Over the last 12 months my ETF model has outperformed my managed mutual fund model with a return of 6.47% vs. 5.26% (both of which are outperforming the 4.1% return of the S&P 500 over the last 12 months).  However, when we look at the 3 and 5 year average annual returns of the same portfolio, the managed mutual fund portfolio nicely outperforms its ETF counterpart.  The 3 year average annual return for my mutual fund portfolio is 16.53% vs. my ETF portfolio which is sporting an average annual return of 15.02%.  The same separation can be seen in the 5 year average annual returns for my two models.  The managed mutual fund model’s average annual return is 6.96% and my ETF model’s average annual return is 5.09%. 
    All we really need to examine is where the markets were three years ago, and recognize what happened between the third and fifth year of return data.  Three years ago the markets were on their way to the lows reached in March 2009.  In between that point and 2007 we had the extreme market plunge which began in the second half of 2008.  A managed mutual fund has the ability to separate itself from the rest of the market near the end of an extreme selloff.  The managers have cash on hand to invest in equities at extremely cheap valuations.  This makes a huge difference in performance because a mutual fund prices at the end of each day based upon the holdings performance within the mutual fund.  An ETF on the other hand prices throughout the day, not based on the underlying assets of the ETF, but based on the amount of shares of the ETF that are bought and sold throughout the trading day.  The ETFs pricing is purely based on supply and demand of the outstanding shares and a manager’s decisions do not affect the performance of the ETF one bit.
    The one thing that disturbs me, more than anything, about the mutual fund/ETF debate is the proclamation that ETFs are a better investment choice because they are cheaper to own.  For me, that is more of a question that comes down to an investor’s time horizon.  I love to use ETFs when I am trying to take advantage of cyclical moves within sectors.  They are very cheap to own and much more cost effective to trade.  Please let’s keep the term “trade” in mind as well as we reflect on Morningstar’s recent report that stated the average non-leveraged ETF is only held for 16 days.  16 days?  That alone should tell us that the debate is between two investment choices that are used differently by the majority of investors.  Still, let me move forward with examining if cheaper to own equals better performance.  The three examples I will be using will be the truest apples to apples comparison you will ever be presented with.  I compared three ETFs from their inception date to a managed mutual fund for the same period of time.  Here is the kicker.  The ETF and the managed mutual funds I chose are offerings from the same financial institution and not only that they share identical names.  Here are the results:
*** All data is from the ETFs inception date to the close of business on February 3, 2012
Vanguard Health Care ETF (VHT) Inception date: 1/26/04 to 2/3/12  +43.32%
Vanguard Health Care Fund (VGHCX) 1/26/04 to 2/3/12  +69.92%
iShares Cohen & Steers Realty Majors ETF (ICF) 1/29/01 to 2/3/12  +214.14%
Cohen & Steers Realty Shares Fund (CSRSX) 1/29/01 to 2/3/12  +237.35%
Columbia Large Cap Growth Equity ETF (RWG) 10/2/09 to 2/3/12  +31.25%
Columbia Large Cap Growth Fund A (LEGAX) 10/2/09 to 2/3/12  +36.04%
    In all three of the above examples the ETF offering from the fund company would have been a cheaper option to own than the managed mutual fund.  However, in all three examples the more expensive to own option would have made you more money.
    I have a horse in both races.  I know what I own and why I own it.  This debate will never be put to rest until investors can begin to clearly identify why they own an investment and what its objectives are within your overall strategy.  Blanket statements such as “Cheaper is better” do not cut it with people that know what they are talking about.   So the next time you find yourself ready to jump on board one side or the other, please realize that there is no correct answer and both sides, at times, can claim victory over the other.
Thank you.  Good luck everyone!
Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success”