Are mutual funds dead? With all of the talk surrounding Exchange-Traded Funds over the past few years, I am starting to think that it's starting to become an endangered species. Although there are way more mutual funds out in the market than ETFs, the popularity of mutual funds is waning while there has been explosive growth in the ETF arena over the past year or two. What's the difference, and is one better than the other?
ETFs and mutual funds are similar in that they both hold baskets of securities. A balanced mutual fund might hold some bonds, T-bills, some stocks and even some cash. An ETF usually holds investments that track a specific index, such as the Dow Jones, S&P 500, the TSX Composite, or the domestic stock markets in any number of countries like China, Brazil or even the MSCI Emerging Markets Index.
The idea in both of these investments is that since you own a piece of many (like hundreds) of investments, your risk is reduced as opposed to owning only one or two companies.
The difference between ETFs and mutual funds is that mutual funds are actively managed, meaning that there's a fund manger who buys and sells shares in the fund, renews bonds and T-bills, and decides on what the fund will own (within the mandate of the fund). For some mutual funds, like an international equity fund, the mandate is quite broad, while for others (energy sector fund) the types of stocks are somewhat limited.
The big knock against mutual funds is that they charge upwards of 2% a year in fees, known as the MER (management expense ratio). That means that each year, the fund takes 2% from you for their services. Vanguard's ETFs, in comparison, have management expense ratios of less than one-half of one per cent, and in some cases as low as 0.08 per cent! Vanguard ETFs just hold your money in pre-defined investments (with negligible cash) and you either sink or swim, depending on how the market does.
That' the one potential down side to an ETF: the risk. Many fund managers hold a larger portion in cash (like 5 to 20 per cent) in cash if they are certain that a market correction is coming. There is no safety net in ETFs if the market (or index) that your ETF takes a nose dive, you are diving along with it.
Although there is no perfect way to predict future returns, a good way to gage the success of any mutual fund or ETF is to look at the 5-year history. Make sure the fund manager has not left (i.e. they have been there for the whole 5 years). With a mutual fund, you are investing in the manager as much as the sector or stocks. With an ETF, make sure to think long term (like 2 to 5 years). Remember, if you owned an ETF that invested in the Dow, the 1987 huge correction would be a tiny blip on an ever-increasing upward slope and you would be saving management fees at the same time.