The short answer is all three are effective investment options. Deciding what is right for you is a combination of preference, costs, and understanding what suits your needs.
An important aspect that applies to all is that the funds you buy or sell are potentially subject to trading commissions, which are charged by your custodian (e.g. TD Ameritrade or Fidelity). Transaction fees can be waived for certain approved funds, so make sure you inquire about your custodian's NTF (No Transaction Fee) funds. Otherwise, your trading costs (typically between $4 - $25 per trade) will reduce your profits.
Before we dive into the debate, one needs to know the basics of each type of strategy. We will start with mutual funds because many of the concepts related to mutual funds apply to index funds and Exchange Traded Funds (ETFs).
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A mutual fund, commonly referred to as "active investing," is a diversified basket of securities that are professionally managed using any combination of stocks, bonds, and money market instruments. Units are purchased at Net Asset Value (NAV), which is calculated by taking the total value of all securities in the fund, divided by the total number of shares outstanding.
Investors pool their money together and their share is invested on a prorated basis across the fund's holdings. Each security purchased by the manager will add or detract from the funds performance. Therefore, all shareholders equally participate in the profits and losses. Additionally, when any one shareholder redeems their shares, it can trigger a taxable event in the form of capital gains, whereby affecting the entire group of shareholders who still remain invested with the fund. This tax inefficiency is one of the major drawbacks of mutual funds, and to a lesser degree, index funds. Taxes are especially costly when a fund does a frequent amount of trading. Fortunately, funds held in IRAs, 401(k)s, and other tax-deferred retirement accounts are not impacted by the capital gains tax issue.
Mutual funds are bought and redeemed through market exchanges like the Nasdaq and NYSE, but the pricing mechanism is clunky because the price (NAV) resets once per day -- after 4:00 PM EST, when the markets are closed. Therefore, an investor might run into a scenario where he/she purchases a fund when the broader markets are down at the beginning of the day, but end up buying the fund at a higher price than expected when the market value rises to finish the day. Due to the after-hours re-pricing feature, mutual funds are not a wise strategy for active traders. They are also not great for beginning investors with less than $1,000 because that is the typical minimum entry amount needed.
All mutual funds charge fees, but how those fees are passed down to the investor varies by the share class structure. There are several types of share classes, but the most common are A, B, C, F1, F2, I, R, Y. Beware A-shares often charge a 5.75% commission and carry higher net operating expense ratios than the other share classes mentioned, with the exception of the B and C share classes.
The reason for multiple layers of fees is that the commission is the advisor's compensation for their recommendation, and the net operating expense covers the mutual fund manager's overhead costs. While every fund has operating expenses, not all funds charge commissions. The I-share class and F2-share class do not because a fee-only planner will overlay their investment management fee as a percentage of assets being managed, rather than charge a one-time commission. As a point of reference, the industry average for investment advisory oversight is 1%, charged annually.
Made popular by Vanguard, an index fund, commonly referred to as "passive investing," is really just a low cost version of a mutual fund. Like their name sounds, an index fund is organized in a way to mimic well-known stock indices. Indices like the S&P 500, Dow Jones Industrial Average, Nasdaq 100, or Russell 3000. The way index funds are bought and sold by investors works just like a mutual fund. The good news for beginning investors is that some index funds don't have the $1,000 minimum like you see with most mutual funds. In fact, Charles Schwab allows for a $1 minimum to purchase their index funds.
Where an index fund truly differentiate itself from a mutual fund is with its cost structure. Unlike a mutual fund, index funds do not charge commissions, which is a big cost savings alone. However, the primary advantage is that index funds generally have significantly lower operating expense ratios. This is due to the passive nature of tracking an index, which requires much less overhead to run the fund and experiences a much lower frequency of internal trades.
To give you some perspective, according to the Investment Company Institute, the average equity mutual fund charges 0.63% versus 0.09% for an equity index fund. To long-term investors, even an extra 0.54% will add up to a meaningful amount over a period of 20 years. Compound interest, or the erossion of it, only magnifies this cost differential. On the other hand, index fund expense ratios are typically higher when compared to Exchange Traded Funds (ETFs), which are discussed next.
EXCHANGE TRADED FUNDS (ETF)
Exchange Traded Funds (ETFs), offer both active and passive investing elements. Like a mutual fund an ETF is a diversified basket of securities. However, they trade in the form of shares on the major market exchanges in real time like a stock, which makes them more nimble than a mutual fund. Meaning, ETFs are a great vehicle for active traders. Furthermore, ETFs offer more efficient exposure to alternative investments like REITs, options, commodities, and convertible securities.
In addition to passively tracking indices like the S&P 500, ETFs are able to package an investment mix that is specific to a sector style like technology or energy. Another popular type of ETF are smart beta funds. Smart beta is still technically a passive strategy in that the fund holdings are usually derived from an index, however, the difference is the fund manager will make tactical investment decisions to change the weighting of an indices stocks based on volatility and other factors. Therefore, ETFs like smart beta have an active trading aspect that deviates from the passive nature of an index fund.
From a tax standpoint, ETFs are much better than mutual funds and index funds because they don't suffer from the embedded capital gains tax issue previously discussed. This means that individual investors can better control when to realize their capital gains. Unfortunately, with mutual funds, investors are at the mercy of other shareholders and the asset manager.
Another advantage of ETFs is that they are often the lowest-cost way to diversify your investments because they carry the lowest expense ratios. For example, Vanguard's S&P 500 index fund (VFINX) has a net expense ratio of 0.14%, whereas, Vanguard's ETF version (VOO) costs 0.04%. It may sound like splitting hairs, but that's more than triple the cost for the same strategy.
Keep in mind, ETFs can be more expensive than index funds when your custodian charges a trading commission. The commission issue is especially problematic for low dollar amounts invested or high-frequency trading. Also, the more expensive the commission, the more mindful an investor needs to be. For instance, a $1,000 investment purchase with a $10 commission equates to a 1% fee. Now add the advisor's 1% fee and you have to make 2% just to break-even.
A TRILLION DOLLAR SHIFT
The latest trend: ETFs and index funds are better than mutual funds. ETFs and index funds have shot up in popularity, so much so that they are all the rage nowadays. In fact, over the last decade over a trillion dollars has shifted from "active" mutual funds and into "passive" index funds and ETFs.
Part of what is driving this trend, according to Vanguard and Morningstar, is that 66% of all active mutual fund managers are underperforming their benchmarks. However, that number doesn't include the funds that have been closed and thus no longer exist. When factoring in the funds that are now extinct, the number of mutual funds that underperformed their respective index was 86%. Woof! Those figures are staggering enough to make investors doubt the merits of active investing.
GIVING THE NUMBERS CONTEXT
So you are saying there's a chance... If the odds of success of beating the index are only 14%, why would anyone invest money in such a strategy? 14% does not tell the entire story. As is often the case, these numbers need more context to paint the full picture. In the United States, as of December 2016, there are a total of 9,511 mutual funds and 1,707 ETFs available to investors. Of the 11,218 total fund options in the US, Moody's estimates that 29% are passive funds. In other words, investors can choose from 3,253 passive funds and 7,965 active funds. 14% of 7,965 means that there are roughly 1,115 active mutual funds that are beating their index during the last decade.
What that really means is there are abundantly more high-quality active funds to choose from than what it sounds like on the surface. The problem is there are way too many mutual funds that are well-below average clouding the picture. That's because most mutual fund companies have a handful of flagship funds that investors flock to, and the rest of their offerings are made available so that an investor can diversify across a number of asset classes through the same fund company. The need for a mass level of offerings at one mutual fund company is especially necessary when an investor could benefit from a breakpoint discount upon buying multiple Class A-share funds. As an example, a breakpoint discount will reduce the 5.75% commission to 4.50% if the investor puts 100% of their $50,000 in American Funds, rather than $25,000 to American Funds and $25,000 to Franklin Templeton. However, with the evolution away from A-share class funds in general, investors can shop across multiple fund companies and cherry pick the funds that are consistently on top.
UNDERSTAND AND FOLLOW A PROCESS
The point is, with proper due diligence and consistent re-evaluation, picking active mutual funds can still be a winning strategy given the 1,115 funds that beat their benchmark over the last 10 years. Contrary to the latest Robo fad, active fund selection is how a skilled financial advisor earns part of their investment management fee.
Unfortunately, picking the winners among all the various mutual funds and knowing how to mix them together is a difficult thing to do. In order to generate enhanced (alpha) results, an investor needs to have a selection process for adding and removing active mutual funds from their portfolio. It's not as simple as picking ABC fund over XYZ fund because ABC did better over the last 5 years. Picking yesterday's winners and overweighting your dollars by following that logic alone is actually one of the worst strategies to follow. It's often why retail investors vastly underperform the markets. According to a study by Dalbar Inc., retail investors over the last 20 years (through Dec, 2015) earned 5.19% compared to the S&P 500 index return of 9.85%. Giving up a differential of 4.66% proves investors are usually their own worst enemies.
An important tip to remember is that when picking among active managers, an investor should know what mutual funds have holdings that barely deviate from their benchmark. Why pay a higher fee for an "active" mutual fund that is really passively managing your money? Anyone reading this should know that selecting high-quality funds takes a lot of work and is not something that should be left for amateurs. It's the reason many do-it yourself investors are gravitating towards lower cost passive ETFs and index funds. Quite frankly, being "average" provides enough growth for most investors to reach their financial goals. Therefore, if you don't have the skill to pick the winners or don't like the idea of outsourcing the process to a professional, then buying passive index funds and ETFs should be your core investment strategy.
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