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Ask the investor: ETFs Taking Over Mutual Funds

  • By Special to The Repository

    Posted Jun. 30, 2014 at 6:00 AM

    If you were on a cross-country flight and your airplane hit severe turbulence, would you rather have a real-life pilot in the cockpit or have the airplane flown by autopilot? This analogous question is often posed by financial advisers in order to try to convince their prospects and/or clients to invest in actively managed mutual funds instead of passively managed funds such as index funds or exchange-traded funds (ETFs).

    The mutual fund was invented in the 1920s. Today there is over $15 trillion invested in mutual funds. Simply put, a mutual fund exists when investors who have a common objective pool their money together so that it can be managed by a professional money manager. Instant diversification and professional money management are two of the main advantages of actively managed mutual funds.

    However, mutual funds also have a number of disadvantages. First, Class A shares of mutual funds that are sold by financial advisors involve an initial sales charge, which may be as high as 5.75 percent. Class B shares of mutual funds do not have an initial sales charge, but they do involve a contingent deferred sales charge (CDSC), which usually lasts for six years. This means that a shareholder will be subject to a declining penalty (from 5 percent in the first year to 1 percent in the last year) if he sells his shares before the CDSC period ends. Class C shares of mutual funds do not involve an initial sales charge, but they are subject to a one year CDSC. There is a 1 percent penalty if a shareholder decides to sell his shares during that period of time.

    Also, actively managed mutual funds have high annual operating expenses. For example, the annual expenses of Class A shares are usually in the neighborhood of 1.2 percent to 1.3 percent for domestic equity funds. The annual operating expenses of Class B shares and Class C shares are significantly higher, although the expenses of Class B shares will convert to those of Class A shares sometime after the CDSC ends. The annual expenses of Class C shares always remain significantly higher than Class A shares. Because of this, they are the most expensive share class to own over a longer period of time.

    Finally, actively managed mutual funds are not tax-efficient since they often distribute capital gains distributions, which are the result of the portfolio manager’s buying and selling of stocks and/or bonds, to their shareholders at the end of the year.

    On the other hand, exchange-traded funds (ETFs), which were created in the 1990s, are essentially mutual funds that trade like stocks. Many ETFs are index-based. ETFs are passively managed, which means that their holdings are infrequently traded. You may think of ETFs as being managed by autopilot. Because of this, ETFs have much lower annual expenses (many around or below 0.25 percent) than actively managed mutual funds, and they rarely burden their shareholders with capital gains distributions. These advantages help to explain why money invested in ETFs has more than quintupled over the past five years.

    Does the roughly 1 percent difference in expenses between actively managed mutual funds and ETFs make that much of a difference? Well, suppose that someone retires at age 65 with $500,000 in his investment portfolio. If his money is invested in actively managed mutual funds and the stock market returns an average of 9 percent gross per year (7.75 percent net of expenses) over the next 20 years, then his investment portfolio will grow to nearly $2.22 million. (Of course, this projection does not consider any tax consequences in a nonqualified account and, as we all know, death and taxes are certain.)

    But what if instead of investing in a mutual fund portfolio the same individual invested in a portfolio of ETFs that averaged an 8.75 percent net return (9 percent gross less 0.25 percent) over the same period of time? In this case, his investment portfolio will grow to over $2.67 million. The difference is over $450,000! (Again, this projection does not take into account any tax consequences.)

    Research studies have consistently shown that the vast majority of actively managed mutual funds (75 percent-plus) fail to beat their respective benchmark. That being the case, why would any investor choose to pay an initial sales charge or be subject to a CDSC, incur higher annual operating expenses, and be exposed to tax liabilities on capital gain distributions when he is most likely going to get subpar performance?

    A 2003 International Air Transport Association (IATA) Safety Report found that approximately 80 percent of airplane accidents are caused by human error. Maybe it is better to hit severe turbulence in an airplane that is being flown by autopilot after all?

    Terry Riffle is the managing principal of Paramount Capital Advisors, LLC, in Louisville. Have a financial question for Terry? Email terry@paramount-ca.com or call 330-915-6114.

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