Though some investors may disagree on preferences between exchange-traded funds (ETFs) and mutual funds, many of them are missing out on what truly counts: your individual investing goals, a sound investment strategy and a commitment to your long-term plan.
ETFs are securities that trade like stocks but are pooled-investment products, like mutual funds, which invest in a basket of underlying stocks, bonds or other securities. ETFs have recently surged in popularity as an investment vehicle. Their rising popularity suggests a growing number of investors may prefer the advantages of these relatively new products over more traditional mutual funds.
In this article, we’ll discuss some recent industry trends and things to consider when evaluating both ETFs and mutual funds.
When comparing the recent fund flows for ETFs and mutual funds, ETFs appear to be attracting more investor capital while mutual funds have seen a slight decline:
While ETF vs mutual fund flows do not necessarily feed directly into one another, they help illustrate ETFs’ rising popularity and mutual funds’ declining usage.
ETFs and mutual funds do have some basic characteristics in common, such as pooled-assets and easy diversification capabilities. However, they may not prove as advantageous for high net worth investors who are able to diversify their portfolios by investing in individual securities.
Like all investments, these products have drawbacks. Investors don’t receive a personalized investment strategy, and, those without a financial adviser may not receive the necessary advice to stick to that strategy. Despite common belief, investors managing their own ETF or mutual fund portfolios—even those using ‘passive’ strategies—may be tempted to sell out of the market once their portfolios have declined some arbitrary amount. This common behavioral mistake can hurt investors’ returns and possibly hinder their chances of achieving their long-term investing goals.
Since 2009, both ETFs and mutual funds have benefited from a long, rising bull market. When the market is rising, indexing—investing by tracking a market index—is easy! With the stock market steaming ahead, index funds have taken center stage, receiving plenty of media coverage. Though some mutual fund managers may find it difficult to weather the recent outflows, this alleged shift of capital into ETFs is largely anecdotal. We don’t think it should have much—if any—impact on the overall stock or bond market.
ETFs and mutual funds are neither universally good nor bad. Instead, their usefulness depends on the investor’s individual situation and the context in which these products are employed. Both can be extremely practical solutions to diversify smaller portfolios. For high-net-worth individuals though, investing directly in those diverse underlying holdings may be preferable as this method provides more flexibility and personalization.
ETFs and mutual funds, though different products, do have some shared characteristics. Here are some basic similarities between them:
While ETFs and mutual funds have a lot in common, here are a few key differences between these products:
Perhaps the most important reminder in the ETF vs mutual fund debate is that these products are not suited for any individual investor. Though you can create a strategic portfolio with some mix of these products, no one ETF or mutual fund is tailored to suit your specific goals and needs. As your financial goals change over time, your passive index funds will not adapt to your more evolved needs. Index funds will change according to their own proprietary strategies, which may not always be compatible with your financial targets.
ETFs and mutual funds serve a wider category of investors. If your financial situation changes, you may need to find another ETF or mutual fund that better aligns with your updated goals. This process of searching for funds that align with your long-term goals can be difficult. Investors who attempt to self-manage their investment accounts may encounter more difficulty and complexity than they’d originally expected.
Many investors have probably asked themselves, “Why hire a financial adviser to customize my portfolio when I can pay less and purchase an index fund to match the market?” This supposedly low-cost method has gained traction in recent years. While it is fine in theory, this strategy is much more difficult in practice. In good times of rising markets and healthy global economies, it’s relatively easy too. Just sit back and watch your portfolio grow! However, when the market loses value due to short-term drops or even longer downturns, investors have a much more difficult time sticking with their long-term strategy. True passive investing would entail never selling your investments until your investing goal is achieved, but few investors have this kind of discipline in hard times.
One study by DALBAR, Inc., shows that equity fund investors typically hold their mutual funds for an average of just four years.iii While trading in and out of your mutual funds every four years may not seem detrimental, it could have consequences. Exhibit 1 illustrates the difference between overall index performance and average performance of equity- and bond-fund investors.
Exhibit 1: Hypothetical Growth of $1 Million Dollars Invested 25 Years, 12/31/1992 – 12/31/2017
Source: “Quantitative Analysis of Investor Behavior, 2018,” DALBAR, Inc. www.dalbar.com FactSet as of 4/6/2018. Barclays Aggregate Government Treasury Total Return Index, 12/31/1992—12/31/2017.
The study attributed investors’ longer-term underperformance to “psychological factors,” or, in other words, poor market timing. One of the biggest hurdles in long-term investing is battling emotion. While index funds and passive investing may be hot buzzwords touting lower costs, a financial adviser may be able to help you stay disciplined to your strategy and stay on track to meet your investing goals. Self-managing’s low cost may mean foregoing the often-necessary coaching needed to stick to your long-term strategy.
Both ETFs and mutual funds offer potential opportunities as well as risks. However, some investors will benefit from having a more personalized approach and the counsel of a good financial adviser. At Fisher Investments, we get to know our clients and help them establish their long-term investing goals. We provide our clients with an Investment Counselor who can provide updates on our current market outlook and help address any concerns you may have about the market.
i “2017 ICI Fact Book,” Investment Company Institute, 2017, p. 59. https://www.ici.org/pdf/2017_factbook.pdf.
ii “2017 ICI Fact Book,” Investment Company Institute, 2017, p. 31. https://www.ici.org/pdf/2017_factbook.pdf.
iii Source: “Quantitative Analysis of Investor Behavior, 2018,” DALBAR, Inc. www.dalbar.com FactSet as of 4/6/2018.