Why I love ETFs — but sometimes love can be blind

5Looking through the newspaper or on the Internet, I often see investment fund companies listing funds they’re offering – and most of these are highly rated 4 and 5-star funds.  So surely that’s the company to choose — are these guys smart or what?
But to quote Winston Churchill “I only believe in statistics that I doctored myself”.

This is because the funds listed do not represent the entire universe that the fund group has — or have had. Fund groups tend to close or merge under-performing funds, distorting the statistics and giving you a false sense of security.
It is a well-known fact that almost 90% of all funds perform less than their benchmark.  So — maybe not so smart after all.

Think of it this way: If I offered you an investment that has only a 1 in 10 chance of beating its no-brainer benchmark and asking you for a lot of fees just to be able to underperform, wouldn’t you would question “why”?
This is one of reasons we are seeing a huge shift in money moving into passive funds, i.e. ETFs. An ETF (”exchange traded fund”) is similar to a mutual fund in that it’s a basket of investments.  An ETF tracks an index, the original and best known, SPDR (Spiders), tracking the S&P 500.  There are a lot of mutual funds that also track the S&P as well, (these tend to be called closet trackers pretending to be active funds to justify the high fees). But with a mutual fund, there is an active fund manager and all of the resultant costs that go towards actively trading every day to achieve the same result at the end of that day – so your return is minus fees: commissions, redemption fees, operational costs, etc. – that can be as high as 3%!  No wonder the size of the ETF market is expected to surpass mutual funds by 2023. Last year USD 326 billion left mutual funds, with an additional USD 429 billion going to ETF’s.  In the last 10 years, USD1 trillion has left mutual funds and flowed to ETFs.  There are also other benefits of ETFs (trading flexibility, tax efficiency) that I won’t go into here, as I’ll bore you another day on those.

Mutual funds can easily be 10 or 20 times more expensive than a passive fund (ETF), which has a cost of about 0.10% and will most likely follow its benchmark. So the goal of the ETF is not to beat the market but to match the market’s performance. The role of an active mutual fund manager is to spot better growth opportunities, achieve better returns and avoid the bad investments.

But as these 90% underperforming statistic shows, the majority of these active mutual fund managers have a poor track record. So why does your advisor show you active funds that can be 10 – 20 times more expensive than a passive ETF – and with historically the 1 in 10 chances of beating the market — versus a passive ETF fund that basically does what the market does. Perhaps one of the reasons why many advisors suggest these types of funds is because they historically pay a trailing commission to the advisor where an ETF does not (this is no longer the case in the UK and other jurisdictions resulting somewhat in a reduction of mutual fund fees). While many active managers are trying to reduce fund costs, there’s a very long way to go (perhaps never) before this benefits clients and results in slightly higher returns.

So, I can see why ETF index funds play an important role in a portfolio, and yet I say my love can be blind as there can also be some dangers lurking.  More on this in my next blog.

If you would like to know more from the author then please contact me at gr@me-group.ae