ETFs Favoured Over Mutual Funds

In December 2010, it was announced that Exchange Traded Funds (ETFs) hit $1 trillion worldwide. And a recent estimate suggests it will double to $2 trillion at the end of 2012. The paradigm shift from mutual funds to ETFs has been a common trend since the introduction of the Internet. Low-cost trading, financial reports, and free researching tools has allowed investors to become smarter and given them confidence to invest on their own. As a result, mutual funds are slowly becoming obsolete, a dying breed that I have never been a proponent of.

My detest for mutual funds stems from two main talking points: the Management Expense Ratio (MER, fancy for manager's fee) and lowered rate of returns.

The MER of mutual funds are well over two per cent. Canada's largest mutual fund by assets under management (AUM) is the Fidelity Canadian Asset Allocation Series B (click on name for Morningstar report) which charges 2.16 per cent, which is considered low in the industry.

Secondly, their rates of return are often very low. The above mutual fund has earned 5.83 per cent (after MER) over the last decade. The comparing benchmark, the Toronto Stock Exchange, has earned roughly 4 per cent per year over the past decade, excluding dividends. When accounting for dividends, it's return exceeds 6 per cent.

Mutual funds also must make public their asset allocation and top holdings. Those who want to mimic a mutual fund's holdings can easily do it without paying a management fee. And if anyone has ever done enough research on mutual funds, Canadian ones especially, you will notice their top ten holdings are often Canadian banks, telecom stocks, and some mining stocks.

These two main problems are resolved with exchange traded funds. ETFs are investment vehicles that mimic an index, benchmark, commodity, or other asset class. The most heavily traded Canadian ETF is the iShares S&P/TSX 60 Index; it tracks the TSX 60 almost exactly. For those looking for American exposure, the SPDR (pronounced spider) tracks the S&P500, the most diverse basket of stocks in North America.

ETFs also trade on the exchanges and provide better liquidity, that is, the ability to sell it immediately and take the cash. Mutual funds are priced once a day, at the end of the day, which means you do not know how much you are receiving or how many units will be sold.

Because ETFs trade on the exchange, you will endure a commission from your broker, but with competition in Canada so fierce, commissions are very low now, often $10 to $30 or lower. And some companies are now providing free ETF trading for a certain period of time.

The only caveat to ETFs are ones tracking commodity prices. Due to contango (a difference in the price of commodity futures from month to month) you will lose out on the monthly spread when one contract expires or is rolled out. Commodity ETFs are meant for trading and not investing, so please take caution.

But before you go and redeem all your mutual funds for ETFs, remember that most ETFs do NOT allow investment plans. Mutual funds do have one positive characteristic that ETFs do not have, and that is the ability to invest small amounts without fees. Those who have monthly or weekly systematic investment plans into mutual funds will not be able to do the same with ETFs without paying the commissions, which will erode earnings.

If you're a young investor with less than $20,000 and want a good way to expose yourself to the market without stock picking, ETFs may be the way to go, depending on your needs of course. They provide great liquidity, the same diversification as a mutual fund, and low cost management fees, if any.