Mutual Funds or Exchange Traded Funds: Which is the better investment solution?

Mutual funds have been a popular investment vehicle for Canadians in recent decades. However, Exchange Traded Funds (ETFs) have risen in popularity recently providing more increased possibilities for investors in today's market.

The Problem: Too Many Choices

There are over 5,000 individual mutual funds available to investors in Canada and over 3,500 ETFs available globally. It can be a very confusing landscape from which an investor much choose.

The main difference between mutual funds and ETFs is 'active' verses 'passive' investment management. Mutual funds are actively managed by portfolio managers who will utilize an investment style and individual research in an attempt to outperform their respective benchmarks. Conversely, ETFs are passive investments which replicate a stated benchmark, such as the S&P/TSX composite stock index.

One of the significant advantages of ETFs are the lower management costs which normally range from 0.1% to 0.5% when compared to mutual funds which typically charge anywhere from 1.0% to 2.5% for equity funds, before advisory fees. Most ETFs use passive investing strategies and track a market index. Research over the past 50 years has demonstrated that long-term index returns match or exceed returns of 'actively' managed portfolios. Creating ETFs that track indexes should therefore match long-term index returns, but cost substantially less than actively-managed mutual funds.

ETF investors must be satisfied with benchmark equivalent performance, minus smaller fees than mutual funds.

It is very difficult for actively managed mutual funds to outperform their benchmark and few of those funds can continue this performance for a prolonged period of time. Over the long run, broad market ETFs outperformed many mutual funds. This makes an investor's decision difficult in finding a mutual fund that will do better than an ETF over the long term.

The problem is exacerbated as consumers because there is very little promotion done for ETFs (since they have low fees/costs) but there is an abundance of marketing from financial companies to promote select funds which have recently outperformed market benchmarks. The percentage of funds companies actively promote is very small compared to the vast spectrum of funds they provide to investors.

Potential Solution: Employ a 'Core-Satellite' Strategy

Both passive indexing and active management strategies do provide an opportunity for outperformance, while reducing overall management expenses of your investment portfolio. One way to do this is with a 'core-satellite' strategy that employs indexing at the core of a portfolio and actively managed funds as satellites.

The conventional view of core-satellite methodology (Figure 1) suggests that it's prudent to use index funds for markets that are deemed efficient, such as Canadian, U.S. or European large-cap stocks. This holds that actively managed funds make more sense to use in areas of the market that are considered to be inefficient, such as Canadian small-cap or emerging market stocks. The theory being that active managers are more likely to succeed in these areas.

As you can see, there are advantages of using both passively managed ETFs and actively managed mutual funds when constructing an investment portfolio. However, most investors don't take the advantage of using both investment vehicles for their long term investment strategies.