Why ETFs Are Beating Mutual Funds

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Includes: IEF, VFINX, VOO, VSIGX
by: ETFguide
Summary

Mutual funds are structurally flawed products when it comes to taxes, trading, and financial flexibility.

Active fund managers are delivering sub-par results despite having the wind in their sail.

Trading costs and expense ratios for ETFs are low and going lower.

ETFs provide financial flexibility that mutual funds can never match.

It's been a long time since the first modern day mutual fund, the Massachusetts Investors Trust, was launched back on March 21, 1924. The roaring 20s are a bygone era, but the arrival of mutual funds left an impression on Wall Street that's still with us today.

Since their birth, mutual funds have dominated and controlled asset flows from the investing public. Combined mutual fund assets topped almost $19 trillion as of mid-2018, according to the Investment Company Institute. Nevertheless, long-term asset flows into mutual funds have significantly decelerated and are now being being captured by exchange-traded funds (ETFs). Let's evaluate some reasons why ETFs are beating mutual funds.

Better Tax Efficiency

Nobody likes paying taxes. But millions of people keep perfecting their mistakes by triggering a higher and totally avoidable tax bill for themselves. The primary way they do this is by investing in mutual funds inside a taxable investment account. Lets' look at a real life example. The below image is a tax comparison of two similar funds - the Vanguard Intermediate Term Treasury Index Fund (VSIGX) vs. the iShares 7-10 Year Treasury Bond ETF (IEF). Although both VSIGX and IEF are assumed to be "tax-efficient" or "tax friendly" because they're both index-based, the actual results show otherwise. Over the past 8 years, IEF has posted zero long and short-term capital gains whereas VSIGX has regularly sacked shareholders with capital gains tax.It's easy to argue the tax liabilities for VSIGX vs. IEF are insignificant. But taxes are one of the leading causes of market underperformance. And since fixed income returns are historically lower compared to other asset classes, any needless expense like year-to-year capital gains tax, are a supremely big deal. The magic behind lower taxes is the superiority of the ETF structure over mutual funds. In our well-received piece titled "John Bogle's Bastardized View of ETFs" we explained how the ability of one shareholder to negatively impact the taxes of another is a gross shortcoming of mutual fund investing. This is a non-existent problem for ETF shareholders. What should you do if you want to avoid the unnecessary risk of higher taxes? The obvious answer is to immediately stop investing in mutual funds inside your taxable account(s). This includes avoiding index mutual funds and even so-called "tax-managed" mutual funds. Instead of putting money into structurally flawed products that increase your tax liabilities, it's better to opt for the structural superiority of tax-friendly ETFs. Finally, not all ETFs are necessarily good at minimizing year-to-year capital gains. Some are better compared to others, so due diligence is required.

Bottom Line

ETFs are better at minimizing tax liabilities than mutual funds.

Superior Performance

Since nobody seems to care about investment performance, let's talk about it. We'll tackle this subject by focusing on a popular category - U.S. large cap funds. After that, we'll take a broader look at other asset classes. The graphic below shows how U.S. large cap mutual fund managers have badly lagged against the S&P 500 index during the past five years. You'll notice as the investment time horizon expanded from one-year to five-years, the performance of active mutual funds got worse and almost 85% failed to beat the S&P 500. Even scarier for those who put their faith in U.S. large cap fund managers is how nearly 85% underperformed during a favorable period for stocks. From 2012 to 2017 the S&P 500 climbed over 110% in value. If fund mangers can't deliver market beating results in favorable times (a bull market), is it reasonable to expect they would miraculously stage a wonderful reversal during an unfavorable times (a bear market)? It would be a mistake for anyone, including us, to judge the performance of fund mangers by exclusively focusing on just one investment category like U.S. large cap stocks. How have fund managers performed in other categories?The graphic below illustrates how the collective underpeformance by mutual fund managers is consistently high in virtually all equity segments - not just the U.S. large cap space. Moreover, the results in the fixed income arena show a similar ominous trend of massive underperformance by fund managers relative to index benchmarks. Is it any wonder why more investors and their financial advisors are abandoning mutual funds in favor of index-linked ETFs?

Bottom Line

Index-linked ETFs deliver better performance results compared to active mutual fund managers in virtually all asset classes and fund categories.

Lower Cost

Investing cost, like love and war, is a thorny subject. For the purposes of this article, we're going to focus on the big-picture macro-economic costs versus the micro-economic aspects. For fund investors, the two biggies are ongoing expense ratios and brokerage commissions for acquiring or selling funds. Let's talk about the first. Expense ratios: It's no secret that expense ratios for ETFs are rock-bottom and heading lower. This is largely due to an ongoing and multi-year price war among ETF giants like Charles Schwab, Blackrock (iShares), State Street Global Advisors (SPDRs), and Vanguard. For example, Schwab's ETF lineup of broadly diversified equity funds carry annual expense ratios that hover between 0.03% to 0.07%.

The already low cost of index ETFs even surpasses corresponding index mutual funds. For instance, the widely held Vanguard 500 Index Investor (VFINX) which has around $417 billion in assets carries annual expenses of 0.14% compared to the much cheaper Vanguard S&P 500 ETF (VOO) which charges just 0.04%. Brokerage commissions: Mutual fund proponents say that ETF acquisition costs make them more cumbersome and expensive compared to mutual funds. In truth, buying or selling mutual funds on a brokerage platform can trigger a trading commission that easily exceeds the brokerage commission for buying an ETF. The key variability that impacts each investor is where they trade. Mutual fund brokerage fees can be avoided, for example, if you operate under the constraints of buying mutual funds on a no-transaction fee list or directly from the fund company where you desire to invest. Ultimately, the idea that brokerage commissions are exclusively applicable to ETFs and not mutual funds is misleading. Let's now talk about the trend in ETF brokerage commissions, which is fast heading toward zero.

As announced last week, Vanguard will eliminate online brokerage commissions for trading on nearly 1,800 ETFs starting in August. Not only will competing brokerage platforms likely respond with similar offers of zero trading commissions on more ETFs, but it now means you'll be able to dollar cost average into ETFs without paying a trading commission. How much of an epic shift will this be? Whatever cost advantages mutual funds previously had over ETFs for systematic savers are now gone.

Naysayers like to argue that ETF investors still have to pay the cost of bid/ask spreads whenever they trade. Don't let these scare tactics alarm you, because what they won't tell you is that bid/ask spreads for high volume ETFs is often zero or close to it. If the bid/ask spread or cost of an ETF is high, it's probably because the fund is a niche-based product with less AUM, less liquid underlying securities, and lower overall trading volume compared to other ETFs. In the dogmatic world of ETF detractors this is horrible news. However, trading ETFs with higher bid/ask spreads is completely OK, if the investor has determined a) there are no better alternatives, and b) the potential lost opportunity cost for not investing in the ETF supersedes the burden of bid/ask spreads. Also, the narrative that mutual funds totally avoid all costs associated with bid/ask spreads is completely false. The stocks held in a mutual fund portfolio, for instance, do have bid/ask spreads. And these embedded trading cost are not free as some claim, but rather are passed on to mutual fund shareholders.

The unwritten rules for the most two important elements of cost for ETF investors are this: 1) Expense ratios for long-term buy-and-hold ETF investors will have a bigger impact on your bottom line cost, whereas 2) trading costs, which consist of brokerage commissions (if applicable) plus bid/ask spreads, will be more meaningful cost-wise for short-term ETF investors. This rule is especially helpful when confronted with the decision of whether to purchase an ETF with zero brokerage costs but a higher expense ratio versus an ETF with lower expense ratio but a commission charge. The right choice all depends on how long you plan to hold the ETF, so choose accordingly.

Bottom line

ETFs beat mutual funds with lower costs.

Financial Flexibility

Investors should demand maximum flexibility from the investment vehicles they choose to park their life savings. And compared to mutual funds, ETFs excel in this area. Unlike mutual fund investors who execute their trades at totally unpredictable and unknowable NAV prices, ETF investors can buy and sell at pre-determined prices with limit orders. If a person is particularly concerned about the difference between an ETF's quoted price and it's underlying NAV, they can check the iNAV and trade only during times when spreads are non-existent or tight. Also, ETF investors benefit from intraday liquidity, meaning they can enter or exit their positions during market hours. Think about it this way: Can you imagine entering Home Depot at 10AM to buy a hammer and having the clerk say you can't leave the store until closing at 9PM? How would that experience make you feel? Would you ever want to shop again at a store with those type of ridiculous limitations? Basically, that's the unwelcome shopping experience of mutual fund investors who are stuck all day inside the store (or market) and limited to executing trades until after the market closes for business. It's a loathe-worthy arrangement!

ETFs provide additional flexibility not available with mutual funds because they can be hedged with put options, assuming the underlying fund has options traded on it. Protecting your capital, especially when market prices are falling, matters. Moreover, investors that want to invest with leverage but skip the process of borrowing money on margin from their broker can choose ETFs that use 200% or 300% daily leverage. What if those leverage points are too high? Direxion Investments just introduced a new lineup of "lightly leveraged" funds called PortfolioPlus ETFs that utilize just 25% leverage. This particular lineup is aimed toward investors that want to use leveraged returns over longer time periods, but without the large daily volatility swings of 2x and 3x leveraged ETFs. The financial flexibility of ETFs will forever be demonized by dogmatic anti-ETF crusaders like John Bogle. But for the rest of us, flexibility is an incredible and much needed benefit.

Bottom Line

ETFs can be leveraged, hedged, bought-and-hold, or bought-and-sold with intraday liquidity and transparency that easily exceeds the flexibility of competing mutual funds.

Summary

ETFs aren't perfect. But compared to mutual funds they have significant advantages. We've articulated this message in our online classes along with this article. As we discussed, mutual funds are structurally flawed products when it comes to taxes, often losing in head-to-head comparisons against ETFs in the same category and over multi-year periods. The performance results for active mutual fund managers, despite having the wind in their sail with a bull market during the past few years, is another nail in the coffin. Furthermore, the trading costs and expense ratios for ETFs are low and going lower. Lastly, ETFs provide everyday investors with much needed financial flexibility that mutual funds will never be able to match. The exodus of assets coming out of mutual funds and into ETFs doesn't lie. It's not an accident or coincidence, but rather, a universal realization by the investing public and financial advisors alike that ETFs are superior investment vehicles.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.