Innovative ETFs Will Make Stale Mutual Funds Obsolete

Empirical evidence shows it’s really hard to beat an efficient market like the S&P 500.  That’s why the majority of mutual fund managers struggle to do that in any given year, let alone on a consistent basis.  Their outperformance, when it does occur, is often more luck than skill.  Active management does have a place in investor portfolios, but we need to be mindful of how we access active strategies.

In our opinion, utilizing mutual funds to get financial market exposure is the equivalent of paying $1,000 for a wooden persimmon driver in golf.  It’s not cost effective and the performance is sub-optimal. 

We have compiled a list of different avenues for expressing active views and the pros and cons of each:

Mutual Funds/Separately Managed Accounts (SMAs)*

Pros:

• Widely available

• Outsourcing of investment decisions to third party

• Diversification

• Saves time

• Liquidity

*SMAs are similar to mutual funds, but can be more tax efficient

Cons:

• Cost

• Underperformance

• Lack of transparency

• Lack of intra-day pricing (price at the close of trading)

• Not tax-efficient              

Exchange Traded Funds (ETFs)

Pros:

• Low Cost

• Tax Efficient

• Explosion of ETFs allows investors to express their views of the market (much lower cost)

• Intra-day Trading

• Diversification

• Transparency

Cons:

• Trading Fees (depending on platform cost can range from free - $15 per trade)

• Liquidity

• Proliferation of exotic ETFs (leverage, inverse etc) can encourage short term speculation

• ETFs can move out of lockstep with underlying holdings due to lack of liquidity/volume

Individual Stocks & Bonds

Pros:

• 100% control of holdings

• Transparency (know exactly what you own)

• No ongoing cost to own stocks & bonds (small commission to purchase)

• Easy to track sources of outperformance/underperformance

• Easy to express a view on the market

Cons:

• Time & Labor intensive

• Behavioral biases of owner/manager

• Potential for lack of checks & balances during adverse markets

• Excessive trading can rack up commissions

In our opinion, mutual funds will be obsolete within 10 years in their current form.  The industry has seen massive outflows due to their inability to adapt to change.  Most active mutual funds have been reluctant to reduce expense ratios.  On the flip side, the major ETF providers (Vanguard, Blackrock iShares, Schwab) have been very aggressive in cutting expense ratios to capture market share.  The result has been intense competition that has lowered the cost of investing.

The ETF industry has also been very innovative in creating new themes and strategies that allow investors to express their views at a fraction of the cost.  The traditional passive vs. active debate will continue to shift due to the evolution of ETFs.  Passive no longer means owning 100% of the S&P 500.  Active no longer means owning a few mutual funds.  The explosion of cutting edge ETF themes/motifs allows investors to build dynamic multi-asset portfolios at a fraction of the cost. 

If you own mutual funds, it’s time to step into the modern age of investing.  You are paying up for an archaic product that has failed to live up to its “promise of outperformance” year after year. 

Full disclosure: Pure Portfolios aims to keep the cost of owning financial assets as low as possible.  That means utilizing low cost, commission free ETFs, individual stocks & bonds exclusively.

FINRA Mutual Fund Analyzer – check out this free toolfrom FINRA.  It shows the dramatic impact of underperformance and excessive mutual fund expense ratios over time.