For decades, investors have turned to traditional actively managed, open-ended mutual funds, an easy-to-manage product that could help them meet their financial goals and deliver potential returns that outperform a benchmark. This benchmark is often a widely followed index.
We’re seeing a growing popularity of Exchange-Traded Funds though (ETF). Created in the early 1990s, these funds address investor demand for intraday pricing, allowing discretion over timing your trades. An ETF is basically a pooled investment fund with shares that can be bought and sold throughout the day on a stock exchange at a market-determined price. Between 2001 and July 2014, the number of ETFs has steadily climbed from 102 to 1,375 according to the Investment Company Institute.
Mutual funds can offer unique strategies not available in the ETF sphere. But if you have both a mutual fund and an ETF—using the first method to outperform the benchmark and the latter to track it—you could compare the performance of your investments in a meaningful way.
Based on Morningstar data and a range of funds available to Singapore and Hong Kong investors up to 31 December 2012, the success of outperforming mutual funds has been established. The findings concluded that: 75% of Asia Ex-Japan equity funds underperformed their benchmarks over a 10-year period.
For other strategies, results were comparable. From the top 20% outperforming funds for the first 5 years, only about 11% remained in the top 20% for the following 5 years. Seeking to be in the top 20% of outperforming mutual funds for a 10-year period is hence not an easy feat!
Could higher expenses be the cause of this?
Compared to ETF, actively managed funds eat up higher expenses due to the extensive research processes required to identify potential outperformers and higher turnover associated with trying to beat a benchmark. Expenses alone however may not be the only reason for this small number of consistently outperforming mutual funds. Fund manager personnel changes, alterations in style, and other factors play a role as well.
Unlike a mutual fund, an index fund maintains its consistency by attempting to closely track the characteristics of the index. Indexing has grown rapidly because the strategy can provide a low cost option to gain investment exposure to a wide variety of market benchmarks.
An investor cannot assume that all index funds will perform similarly and should not expect indexed strategies to outperform all actively managed funds in a particular period. But it is clear that lower costs of roughly 0.5% a year compares favorably to costs of 1.5% for most equity mutual funds.
For ETFs, the price fluctuates during the day and the quote may differ from the Net Asset Value (NAV). A bid-offer spread is built in as they are traded in the secondary market. A mutual fund is always bought at NAV, as there is no intra day pricing involved. Buying and selling an ETF therefore does take a bit more of attention.
The growth of ETF investing is likely to continue as it takes away the need for finding successful fund managers, though ETFs will track the index and thus never outperform. They satisfy the investment needs of a large group of investors who wish to stay close to market performance. Before plunging in, investors should be mindful of the different ETFs available out there and choose wisely, being aware of timing issues related to quotes that fluctuate around NAV.
Do you have any experiences or insights to add in terms of mutual funds versus ETF investing? We’d love to hear your thoughts in the comment box below!