Marc Lichtenfeld: Why I Prefer ETFs Over Most Mutual Funds

Last week, I wrote about the miserable track record of actively managed mutual funds and how you are practically guaranteed to underperform the market if you invest in one.

That prompted an email from Dave M., who asked if I feel the same about exchange-traded funds.

ETFs are baskets of stocks that usually have a common theme. Some cover a specific sector, others track a certain index. The SPDR S&P 500 ETF (NYSE: SPY) is one of the most popular. It allows investors to essentially buy the entire S&P 500 for $210 per share.

[ad#Google Adsense 336×280-IA]If the S&P goes up 10% in a year, the SPY should rise by just about the same amount (there may be a slight difference due to expenses).

And if the S&P drops 10%, so should the ETF.

To answer Dave’s question, no, I don’t feel the same about ETFs as I do about mutual funds.

For one big reason.

First, let me be clear. My dislike of mutual funds applies only to actively managed funds – where a manager and their team are conducting analysis and deciding which stocks belong in the portfolio. The vast majority of these funds grossly underperform the market every year.

Mutual funds that track indexes are fine – and they typically carry much lower fees than actively managed funds. The Vanguard Total Stock Market Index Fund (VTSMX) – part of Alexander Green’s Gone Fishin’ Portfolio – is a good example. It has an expense ratio of just 0.16%, which means for every $1,000 invested, your expenses are just $1.60.

Compare that to the actively managed American Century Equity Growth C Fund (AEYCX). You pay 1% just for the honor of getting into the fund. So if you invest $1,000, only $990 gets put to work. American Century keeps $10 right from the start.

Then you’ll pay an outrageous 1.67% expense ratio per year. And what do you get for all of those fees? A fund that has trailed the S&P 500 over the past one, three, five and 10 years.

I’m not picking on American Century. Most actively managed funds overcharge and underperform.

ETFs work differently in that most are not actively managed. As a result, their expenses are tiny. The SPDR S&P 500 ETF charges just 0.09%.

For a more hands-off approach, ETFs that are tied to indexes or sectors are an excellent way to set up your portfolio. You will pay a commission to buy and sell them just like a stock. That’s not the case with most index-tracking mutual funds. The fees on a mutual fund might be a bit higher, too.

Remember, the Vanguard Total Stock Market Index Fund charged 0.16% versus 0.09% for the SPDR ETF.

Now, there are a few actively managed ETFs out there, but most are too new to determine their success. Interestingly, this week on Oxford Club Radio I interviewed legendary trader Blair Hull. He’s the founder of the Hull Tactical U.S. ETF (NYSE: HTUS), one of the handful of actively managed ETFs.

Not only does Hull expect his ETF to outperform the S&P 500… but he says the model it’s based on can actually predict where the market will be six months from now. Since inception last June, the Hull Tactical U.S. ETF has climbed 4.16% while the S&P 500 slipped 0.15%. So maybe he’s onto something.

The fund is off to a good start, sure. But one year does not make a track record. And I’m sure Hull would say the same thing. (If you’re interested in hearing where he thinks the market will be at the end of the year, you can listen to my full interview with him here.)

Returning to my original point…

Investors can usually do better managing their portfolios with ETFs and index-based mutual funds versus having a mutual fund manager do it for them.

Over the long run, this approach will certainly be cheaper. And, as we’ve seen year after year, actively managed mutual funds have proven that they can’t beat the market.

Good investing,

Marc

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Source: Investment U