David Peartree, The Daily Record Newswire
If mutual funds did not already exist, is there any chance that someone now would propose to create them? It seems highly unlikely. The surge of interest in Exchange Traded Funds over the past 10 to 15 years has made traditional mutual funds look increasingly dated.
Let's assume that the traditional open-end mutual fund did not exist and that some investment company proposed to bring to the market an investment fund that trades and is priced only once a day. What an arcane idea! Why would any investor opt for such a constrained investment vehicle when they could invest using an ETF that is constantly priced and trades throughout the day?
Not so fast. Mutual funds may no longer be the wave of the future but neither are they ready for the dustbin of history. For all their merits, ETFs are not always an investor's best choice. There is a case to be made that traditional mutual funds, not ETFs, will remain the investment vehicle of choice for many investors.
Traditional mutual funds have been around longer than most investors realize. The mutual fund as we know it dates back to 1924 with the creation of the Massachusetts Investors' Trust in Boston. That fund eventually led to the creation of the firm that still exists today, MFS Investment Management.
ETFs have existed only since 1992 and have only grabbed significant market share over the past 10 years. When they were first launched, their proponents argued that the daily liquidity offered by traditional mutual funds was no longer good enough.
Why should investors be limited to once a day trading and "forward pricing?" Forward pricing means that an investor placing a trade during the market day does not know the price at which the purchase or sale will execute until after the market closes, typically 4 p.m.
Unlike traditional mutual funds, ETFs offer investors intraday pricing and the ability to immediately execute their trades. Moreover, ETFs allow investors to sell shares short or to buy them on margin, options are that not available to investors using traditional mutual funds. ETFs are more complicated than traditional mutual funds and that presents some unique issues.
The mechanics of trading ETFs present investors with some challenges not faced by investors using traditional mutual funds. Many ETF investors routinely place buy or sell trades using market orders. A market order guarantees that a trade will execute but not the price at which it executes. At times the market can quickly move away from the price showing on a computer screen and the result can be a purchase or sale at a price very different from the one the investor was expecting.
The "flash crash" of May 6, 2010, offered a hard lesson for many investors. Over 20,000 trades that day were executed at prices more than 60 percent away from the price that was reported only minutes earlier. Fortunately, these trades were reversed after the SEC determined they were "clearly erroneous." Unfortunately, trades that executed at a price only 59 percent or less away from the price reported only minutes earlier were upheld. Those investors suffered the consequence of casual trading.
The lesson for investors was clear: ETF investors should use market orders cautiously, if at all. The better practice in most cases is to use a limit order that sets the price at which the trade can execute. A limit order, however, requires just enough additional effort to set up and monitor that many investors get sloppy and take their chances with a market order.
ETF trades can also be more complicated than mutual fund trades for other reasons. Investors need to pay attention to bid/ask spreads and the size of premium or discount relative to net asset value. Ignoring these factors can result in trades that are more costly than an investor expected.
ETFs also have a longer settlement date (trade date +3 days) than traditional mutual funds (trade date + 1 day). This means it can take longer to reposition funds following a trade.
Trading in ETFs is more complicated, and this requires greater care by investors. The things that make ETFs unique intraday trading, the ability to take short positions and the ability to buy on margin are generally of interest only to speculators as opposed to long-term investors.
Evidence also suggests that the relative ease of trading ETFs may be encouraging many investors to engage in more short-term, speculative trading compared with investors in traditional mutual funds. ETFs generally show much higher rates of turnover indicating more frequent trading by ETF investors.
Studies have documented the tendency for investors to capture lower returns than the returns of the funds they use. This is because of market timing, excessive trading and other self-destructive behaviors.
Both ETFs and mutual funds can offer convenient access to broad diversification. If the choice is between using a traditional mutual fund with a high expense ratio or an ETF with a very low expense ratio, ETFs may offer a clear advantage.
If the investment strategy calls for index tracking funds, then an ETF may not offer any material advantage over an index tracking mutual fund. It may simply come down to which costs less, and ETFs don't always cost less.
If an investor is going to be trading on his or her own, without an advisor's help, that investor needs to know how to trade ETFs properly to mitigate risk and cost. Otherwise, he or she may be better off sticking with traditional mutual funds.
Mutual funds are not better or worse than ETFs. They are different investment vehicles with some similarities but striking differences. Investors need to evaluate which works better in their circumstances.
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David Peartree, JD, CFP is the principal of Worth Considering Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
Published: Fri, Jan 23, 2015
