There is an ongoing debate in the market about which investment fund type investors should choose to achieve their financial goals: mutual funds or exchange-traded funds (ETFs). My argument is that there is no need for this either/or decision. Both products can co-exist in a well-diversified portfolio of investments.
In fact, having both mutual funds and ETFs as investment options offers investors unparalleled choice and enhances the ability of advisors to create portfolios that best meet their clients’ needs.
The key is for advisors to understand the similarities and differences between ETFs and mutual funds and how these products can each play a role in helping clients achieve their financial objectives.
In terms of product structure, there are more similarities than differences.
ETFs and mutual funds are both professionally managed, pooled investments with built-in diversification and liquidity. They are also regulated under the same rules. Both vehicles offer a full range of investment strategies, including pure passive, smart beta, active management, and highly differentiated active management strategies with minimum constraints. They both offer access to a full range of asset classes, from money markets to equities and bonds, and across domestic and international markets.
The boundaries between ETFs and mutual funds is blurring somewhat; fund companies are combining ETFs in mutual fund structures, making them accessible to more investors.
Here’s where they differ.
Mutual funds have been around longer, so some funds have a very long performance track record, compared with the majority of ETFs, which is a newer product type.
There are currently more mutual fund product choices. Today, there are more than 3,300 Canadian mutual funds available. There are currently 615 ETFs listed in Canada, and more products are coming on stream at a rapidly increasing rate. The number of ETFs has more than doubled in the past five years alone. There is a greater variety of passive index strategies in ETFs and a greater variety of active investing strategies in mutual funds.
ETFs offer greater flexibility in trading. Because they trade on an exchange, they offer investors the same trading flexibility offered by stocks, including the ability to time trades; to set limit orders and stop-loss orders; to purchase on margin; and to sell short.
For the most part, it is easier to make smaller purchases of mutual funds on a regular basis. Because of brokerage commissions, buying ETFs with smaller dollar amounts every couple of weeks or every month can be inefficient and costly. However, the good news is that there are a growing number of purchase options now offered for ETFs, from robo-advisors to online brokerages with pre-authorized contribution plans.
Mutual funds and ETFs both have ongoing costs in the form of management expense ratios (MERs), comprising management costs, operating costs, administrative costs and taxes; and trading expense ratios. When trading ETFs, you also have to be aware of the potential costs associated with the fund’s bid/ask spread, which can fluctuate.
ETFs generally have lower MERs than mutual funds, largely because the majority of ETFs are passively managed and the majority of mutual funds are actively managed. While low-cost, passive funds still dominate the ETF landscape, there are a growing number of actively managed ETFs in Canada — again blurring the lines to some degree between the two fund types.
The MERs of the majority of mutual fund assets include trailers, representing the cost of distribution and advice. This structure currently accounts for almost 85% of all fund assets in Canada. For ETFs, the cost of distribution and any advice received is generally paid as a separate fee.
As of July 31, 2018, there was almost $1.7 trillion in total fund assets, so it is clear that Canadians recognize the value of investment funds and the role they play in building financial security. Having access to both ETFs and mutual funds provides investors and advisors with a wider range of products, investment strategies and distribution channels that allow for customized portfolios.
If there is a debate about which product type to choose, the simple – and often best – answer is: both.