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Mutual funds or ETFs: In which to invest?

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If you’re in the mood for some good news, I’ve got your back!

Mutual fund companies, and ETF providers to a lesser extent, are lowering their fees. I’m sure it’s nice to know they’re looking out for the average investor, isn’t it? Or, could it have something to do with new regulations being placed on the industry? Hmm…

Effective January 2017, investment statements will have to include an itemization of each investment product and its cost to the investor. Once this happens, people will be more likely to take a closer look at the appropriateness of those costs relative to their performance. If adequate answers are not evident, something will need to change. In anticipation, investment providers have been trying to minimize any potential issues before things become fully transparent.

If you find it bothersome that it’s taken a regulatory change to bring this about, you’re not alone. In my 20 years as a financial advisor, one of my biggest pet peeves is the high management fees I see mutual fund companies charging. Another pet peeve is the high fees I see other advisors in the industry charging, but that is another rant!

When I started as an advisor in 1996, mutual funds were brand new and we spent a lot of time teaching our clients what they were, how they worked, and their benefits. In those early years, they were the best tools available for most investors who wanted a diversified portfolio (both by region and in the number of individual investments within each holding). Mutual funds were also great alternatives to buying and selling individual stocks on your own—a strategy that carries a much bigger risk, especially if you don’t have a lot of time to do your own research.

However, we’re not in 1996 anymore. We’ve since learned that although a carefully selected mutual fund has its place in a portfolio, most of them underperform the index they are pegged to over the longer term. Yes, there are a few questionable fund managers out there, but this underperformance isn’t usually due to a fund manager’s incompetence. Rather, it has to do with his or her inability to make up for their high fees.

It should also be noted that some mutual funds do match or outperform the index they are pegged to, especially in sectors where there is a large variance between holdings and where an expert may have a significant information advantage over the average investor.

Exchange traded funds (ETFs), on the other hand, offer diversified holdings at much lower fees, generally-speaking. But be careful; ETFs can differ greatly from each other. For example, passively run ETFs are often market indexes, like the S&P 500 or TSX, which can be bought as a single security on the stock market. These types of ETFs usually have low fees. The ETF I use for the Canadian allocation of our portfolios charges only 0.05%, which, when you compare it to the average Canadian equity mutual fund (usually between 1.25-1.5%), the funds are about 25 to 30 times more expensive!!

But then we have actively managed ETFs. They’re, well, actively managed, and in many ways are like a mutual fund. They often charge in the 0.50-0.95% range—not as cheap as passive ETFs, but usually a better deal than mutual funds, assuming we’re comparing similar asset classes.

In fairness, at this point, most of the active ETFs tend to be rules-based computer models and are often based on algorithms, as opposed to a team of analysts and managers who research and manage a mutual fund, but the lines are already beginning to blur between them.

I’m not saying you should choose your investments based solely on their fees. There are reasons to own actively managed ETFs and mutual funds, the most prominent being diversification. A portfolio only comprised of passive investments will likely have a higher correlation to each other, meaning in bad markets your portfolio may not have the downside protection you’d like and need. This lack of diversification could also hurt your long-term performance, as the benefits of rebalancing will be reduced.

So let’s raise a glass to lower fees! Hopefully, these trends continue, and investment fees keep falling, regardless of the reason!