It is the question that I get asked the most: “What is the better investment, the ETF or the mutual fund?” There is no easy answer, so lets look at the differences.
Mutual funds begin with buckets of cash and a (hopefully) top-notch investment team. The fund is then marketed by salesmen to the public. The fund manager is more often than not, a stock picker with a particular brief. The quality of the fund manager determines the success or otherwise of the mutual fund.
ETFs work almost in reverse. They begin with an idea -- tracking an index -- and are born of stocks instead of money.
What does that mean? Major investing institutions like Barclays or the Deutsche Bank control billions of shares. To create an ETF, they simply transfer a few million of them, putting together a basket of stocks to represent the appropriate index, say, the Nasdaq composite or the Shanghai Stock Exchange.
They deposit the shares with a holder and receive a number of creation units in return. Creation units are the building blocks of an ETF. One creative share represents each individual stock within that ETF. Dependent upon the ETF and the weighting of the index, there could be 50,000 shares within a creative unit. The creation units are then split into individual shares for public consumption.
So, then what are the differences?
There are many, but rather than being fundamental, they tend to be nuanced.
For example, a mutual fund often has a minimum subscription of $50,000 or more. This is not the case with ETF’s, which have no minimum whatsoever.
As a mutual fund becomes more successful, more shares are purchased. In an open-ended mutual fund, additional shares do not dilute the net asset value (NAV) nor should they radically affect the value of the underlying assets.
A disadvantage of an ETF in an illiquid index (such as some soft commodity markets) is that the ETF can fundamentally change the price of the asset rather than reflect it. This has led to price fluctuations in markets such as corn and even oil. Many hedge fund managers favour the ETF because of its inherent flexibility.
But no investment is perfectly structured. Imagine, that you own a lump sum portfolio and it’s 10am in New York and the markets are tanking. The S&P 500 is 3% down and looking as if it has further to fall. You call me and ask me to sell immediately. I then immediately fax a sell instruction to the portfolio bond provider and the ETF is sold within the next few minutes. I can also take advantage of the declining market by buying short ETF’s.
Another client with another Tokyo brokerage owns mutual funds. He too, is spooked by a market down 3% and calls his broker who accordingly, faxes the provider who places the sell order. If the client is lucky (very lucky), the mutual fund will be sold at the end of the working day. Far more likely, it’ll be the end of the week or month or quarter with potentially horrendous damage to repair.
The ETF has also been bought and sold at a very low cost (less than 0.15%) whereas some mutual funds from boutique managers (usually fund of funds) can have redemption penalties of 5% or even more.
However, the story is not completely one sided. Whilst there are benefits to ETF’s with lump sums, there are also benefits to mutual funds with savings plans, particularly with regard to dollar cost averaging.
Dollar cost averaging demands that comparatively small amounts of money are invested on a regular basis into an investment. Here the mutual fund has an advantage. Because we are averaging, we are not going to sell should the NAV of the fund drop. In fact we initially encourage losses in order to build up additional units bought at discount. Additionally, because the mutual fund also holds cash, its position is slightly more defensive.
The ETF however, has a zero cash position and much higher expenses (brokerage fees etc) particularly if you buy very small amounts on a regular basis. Conversely, the costs of investing in a managed mutual fund based within a monthly contribution offshore savings plan with a major institution are comparatively low. Offshore mutual funds within a formal savings plan often have no bid/offer spread and they have unlimited switching.
So the answer to the question of “what is the better investment, ETF’s or managed funds?” is not simple. I generally prefer ETF’s for lump sum portfolios unless I come across something very special from a fund manager. However, within a monthly savings plan the managed mutual fund concept works very well indeed.
In my opinion, both of these popular investment vehicles have a viable future. The ETF industry will continue to grow at leaps and bounds, but there will always be a place for investments managed by people.
No comments:
Post a Comment