Experts debate ETFs, mutual funds

Few debates stir as much passion among investors as the relative merits of mutual funds versus exchange-traded funds. Investors who love ETFs love them a lot, questioning why anyone would pay more for mutual funds that fail to beat their benchmark. On the other hand, mutual fund fans question the wisdom of micromanaging a portfolio of semi-opaque securities.

At times, it seems they’re mutually exclusive and never the twain shall meet. But that’s just what happened at the Morningstar Investment Conference, when representatives of every possible angle of the debate met to hash out their views.

Challenges of ETFs

ETFs have been given a relatively easy ride in the press, but questions are now arising about transparency and pricing, providing ammunition to the defenders of the traditional mutual fund.

Far from being the great democratizers of the investment industry, ETFs present challenges to the uninitiated, who don’t know about the tricks of trading, said Tom Bradley, president and co-founder of Steadyhand Investment Management, which employs a traditional mutual fund structure. There are problems with the pricing of ETFs, which few investors understand – problems that don’t exist among mutual funds.

“I think a lot of our clients are happy to know they get net asset value to within four decimal points,” Bradley said. “We have to educate, you have to be smart about trading – don’t trade in the first 15 minutes or the last 15 minutes. I think it speaks to the complexity of that delivery system.

“I think the mutual fund industry is doing itself a disservice by not shouting from the rooftops ‘you’re going to get exactly net asset value and you don’t have to worry about it at the end of the day.’”

Peter Intraligi, president and chief operating officer of Invesco Trimark, agreed, saying clients can be caught in a wide bid-ask spread when trading an ETF on the Toronto Exchange, as it doesn’t publish an indicative NAV.

However, Som Seif, CEO and director of ETF provider Claymore Investments, pointed out Canada’s system of multiple market makers provides enhanced transparency, and keeps bid-ask spreads far tighter than in the U.S. market. Besides, mutual funds have their own trading problems: investors can only get that highly accurate NAV at one point in the day, whereas an investor can exit an ETF at any point.

“Ultimately, the flexibility to trade like a stock is there for investors as an added bonus. It doesn’t mean you need to trade it.”

The most popular ETFs – those with broad market exposure – are to be held long-term, he said, and the perception that ETFs are best suited to active traders is “absolutely false.”

As for investors not getting NAV on the sale of an ETF, Seif pointed out this cuts both ways: an investor using a limit order at the end of a trading day may be able to buy at a cost below NAV.

“The ETF structure has clearly won the day on the passive side, but on the active side, investors have had no choice,” said Ken McCord, president of AlphaPro Management, Canada’s only provider of actively managed ETFs. “I think the active [management] investor will choose the ETF structure over the mutual fund structure for the very same reason the passive investor has chosen the ETF over the mutual fund structure.”

Active or passive?

For the smaller investor with less than $100,000 in assets, cost becomes a real concern, and the scales tip in favour of ETFs, said Heather Pelant, managing director and head of iShares, the ETF division of BlackRock Asset Management Canada.

“There are a lot of things that are antiquated about [mutual funds],” she said, pointing out that there’s been little innovation in the structure since the 1940s. “ETFs are fundamentally a better mousetrap. They allow investors to have that precise control that comes with a stock, yet allows them to be diversified with a broad-based index.”

Panel moderator Rob Carrick commented on how “wide and deep” the number of funds was that routinely couldn’t beat the index. One of the key pieces of evidence against active management is the quarterly SPIVA report.

“Active management is tough,” says Pelant, who worked on the active-management side before moving into the ETF market. “In some asset classes – fixed income – it’s virtually impossible for managers to beat the benchmark.”

But “SPIVA really is apples to oranges,” said Bradley. “It compares funds that have advice built into them and it includes a bunch of funds that are closet indexers, to the index which has no fee attached, no trading commission, no account fee, no anything.”

As an investment performance tool, SPIVA is practically useless, because it compares active funds to a benchmark that’s not investable. The scorecard simply compares mutual funds to the most similar S&P index. Investors wanting exposure to that index through an ETF would still have to pay management fees and trading costs.

“If you impute some costs to owning ETFs (which are low-cost products, I’m not denying that), I think the SPIVA survey starts to look quite different, and in some asset categories, quite favourable toward funds.”

A final flaw in the report is that it’s structured in such a way as to bias the results, comparing fund structures with the highest fees. “I think it’s unfair to talk about actively managed mutual fund fees at 2% or 2.5% and compare them to just the underlying price of an ETF,” said Intraligi. “If you want to compare apples to apples, it’s a better comparison to look at Series F pricing.”

That would ensure the cost of advice was factored out of both the active and passive strategies.

One of the long-standing debates has been over the relative merits of active versus passive management. But on this topic, there’s now a general, if qualified, consensus.

“Smart investors have both,” said Pelant. “You get that blend right, which is what the biggest institutions in the world do, [and] you [have] a really nice ability to help the client navigate the rough waters, still get that little bit of outperformance, but still anchor them.”

Bradley’s sharpest criticism is not of ETFs, but of index-hugging mutual funds that purport to offer active management. Investors who plan to build a portfolio of ETFs and mutual funds should be careful they invest in mutual funds that really do diverge from the index, he warned.

“I believe that good active makes a lot of sense. You couple that with good passive, and you’ll do really well,” said Seif. “That’s the future of the industry. We’re seeing that institutionally, and we’re starting to see that globally in the broader retail space.”

Bradley is not convinced the average investor has the capacity to properly manage a portfolio of ETFs, and he isn’t sure the advisor wants to spend his or her day rebalancing these assets.

“I think with funds, there’s more decision-making in the hands of the people who should be making decisions: the investment managers,” he said.

“As you move into the ETF world, you’re putting more on the shoulders of the advisor and the client, as far as asset allocation and sector rotation. If I had my druthers, I’d have that in the hands of the pros who do that all day, rather than in the hands of the client.”