Which Is Better: ETFs Or Regular Mutual Funds?

Chief Investment Officer Jared Kizer and Tim Maurer discuss the similarities and differences between ETFs and mutual funds. While they stack up fairly equally along diversification and tax efficiency, there are very different strategies you can employ in both structures.

Transcript

Tim Maurer:

Hello, Tim Maurer, back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders. Today’s question will be answered by Jared Kizer, Chief Investment Officer of Buckingham Wealth Partners. And Jared, today, we’re talking about ETFs or exchange traded funds. How are they similar or dissimilar from regular mutual funds?

Jared Kizer:

So there’s certainly a lot of similarities there. So they tend, if you look at both mutual funds and exchange traded funds, they tend to follow very, very high-level similar investment approaches. So most of them are dedicated to kind of diversified stock and fixed income investing. So if you looked at what would be inside, if we took the wrappers off, you would see a lot of, at a high level, the investment strategies can be pretty similar. So there is some similarity from that perspective. So high levels of diversification, generally going to be very tax efficient and lots of different strategies that you can employ in both structures.

Jared Kizer:

Another similarity is that as we all know, there’s a lot of assets that are being managed in both at this point. There was a time at which maybe 15, 20 years ago where nobody knew exactly where the exchange traded fund structure was going to go. And we certainly now know that both of these structures are here to stay at this point.

Jared Kizer:

So lots of similarities, but as you noted some notable differences as well. I think the thing that always comes to mind for me is that an exchange traded fund in terms of how it trades is probably best thought of as similar to an individual stock, meaning it’s going to trade kind of throughout the trading day, it’s not going to therefore trade at a single price like a mutual fund does where you get that net asset value at the close of every day. It’s trading throughout the day at a range of prices throughout the day, and is also impacted by how much liquidity there is in that particular ETF.

Jared Kizer:

So you’ll see, for example, that ETFs that are in bigger stock focused or have larger amounts of assets under management will tend to trade at lower overall transaction costs than some less liquid ETFs. So there’s certainly some things to be aware of on the trading side that you don’t really ever have to bother yourself with on the mutual fund side, where you know, every day I buy or sell, it’s going to be at that same net asset value for a traditional mutual fund. And that’s just not the case with an exchange traded fund.

Jared Kizer:

And then last thing that comes to my mind that I don’t know whether you put it in the difference or similarity case, because I think for the types of strategies that we recommend, again, broad diversification, tax efficient, low cost, a lot of those things are very, very similar across the two, but you will hear people on both sides of the spectrum argue, well, the ETF structure is just way, way more tax efficient and others that would say, no, that’s not really the case. So I think that one is you tend to find people arguing both sides. I think our perspective would be that managed correctly, both structures can be very, very tax efficient. Maybe you give a slight edge in some cases to the exchange traded fund structure from a tax efficiency perspective, but probably more similar there than lots of people would believe based upon what you’ll hear from some of the fund companies that are out there.

Tim Maurer:

Yeah. Interesting. You mentioned 10 or 15 years ago, we were wondering where might ETFs go? And it’s funny, because I can remember talking about them and seeing them and experiencing them back then. Right now, Jared, if we looked at the total fund landscape, could you give us an idea of what percentage of it is made up by ETFs and what percentage is made up by regular mutual funds?

Jared Kizer:

Yeah. So with everything, it depends upon a lot of ways in terms of how you measure it. But I would say it seems like it’s somewhere in the neighborhood of 20% to 30% in the exchange traded fund world, maybe a little bit higher than that in the balance and the traditional mutual fund structure. A lot of people might guess that it would be a lot, lot higher percentage in the exchange traded fund space, but as with everything you have to keep in mind as we started off with 15 or 20 years ago, this thing basically didn’t exist.

Jared Kizer:

So that is a huge, huge fraction of market share to have captured over what in the grand scheme of things is a relatively short period of time as far as financial markets go. And it really shows no clear end in sight, if you look at the flows kind of year over year. You definitely see that flows are trending in the direction of the exchange traded fund structure.

Jared Kizer:

But I think that disguises a little bit in terms of what the true, true driver is. Part of it, no doubt is that people want ETFs. But part of it is, it’s kind of a poster child for the big, big shift in investing toward low cost, toward tax efficiency, toward all the things that have driven the index mutual fund space and funds from fund companies like Dimensional and others. So I think of it in that way as part of a bigger trend in the direction of kind of rules-based investing that we know and love. That’s probably the bigger driver of why we’ve seen the big uptake over time.

Tim Maurer:

Yeah. So do you think that ETFs have actually played a meaningful role in helping drive down the cost of overall fund management?

Jared Kizer:

Absolutely. I think if you look at that front, you can point to certainly exchange traded funds and to Vanguard. I mean, those are the big two drivers I think, of the lowering of investment expenses over time. And of course, Vanguard has exchange traded funds, so there’s some overlap there. But I think, yeah, the entrance of Vanguard, the entrance of folks like BlackRock, iShares on the exchange traded fund side, I think that structure because it’s mostly always been about index-based strategies and we know index-based strategies naturally tend to be low expense strategies, so I think that has certainly been a driver of overall fund expenses going down over time. And again, a driver of a lot of assets leaving the traditional active space into either the ETF-type structures or similar structures on the open-ended mutual fund side.

Tim Maurer:

Sure. All right, Jared. So now it’s time for the question that we all want to know the answer to. Which one’s better? Which one should we be using?

Jared Kizer:

Right. So a little bit of a disappointing answer.

Tim Maurer:

Oh, boy.

Jared Kizer:

Either one of the two can make sense. I think a couple of things to keep in mind as you’re sorting through that decision, I think generally if you have flows going into your portfolio on a frequent basis, even though a lot of ETFs trade with no commission cost on some platforms, they still have kind of this bid ask spread trading costs. So probably not ideal for those situations where you’ve got a lot of trades over a period of time, say you’re building out your portfolio or you’re investing in some way where you’re having flows go in pretty frequently, maybe not the best for ETFs in that particular case.

Jared Kizer:

If you’ve got a situation where instead you’re investing most of the portfolio all at once, maybe a slight edge to the ETF space there. One of the cons I would say in terms of one of the reasons why we have not historically been heavy, heavy users of ETFs, as much as we like index-based strategies, we know pure index-based strategies do come with some potential negatives related to particularly the ability of investors to potentially front run what the manager is doing, kind of trading ahead of the index fund managers.

Jared Kizer:

So you get a lot of those same issues on the ETF side, but one thing that is changing there, you are starting to see ETFs launched that aren’t kind of purely transparent index-based strategies. So I think the field is certainly starting to level there. And I think it’s heading toward more and more leveling out as time progresses. So I think to your question, probably another year or two, there really won’t be large differences that you can draw across one compared to the other. We’re almost at that point now I would say. There are some differences, but right now they’re on somewhat of a level playing field I would say.

Tim Maurer:

So. Absolutely it should be a consideration, but not necessarily right in every single situation. Am I hearing you correctly?

Jared Kizer:

Yeah, that’s correct. And I’d say another way you could just summarize everything I just said is that you can basically build up portfolios that are ETF-like from traditional mutual funds that are low cost, that are tax efficient. So by and large, there are some notable things about ETFs compared to funds. I think almost all of that relates to the trading differences, not nearly as much to say, hey, the ETF structure is just naturally better than the traditional mutual fund structure. I think a lot of that is overplayed at this point.

Tim Maurer:

Yeah. And I think if you wonder, could there be a potential downside to the seeming ease of trading in and out of ETFs, it may just be a behavioral thing, but that’s an advantage that wouldn’t we generally say is not one that we would hope many investors would take advantage of because you could have a passively-oriented or index-based ETF, but if you’re trading in and out of it, you could still be falling prey to the same dangers of active investing. Correct?

Jared Kizer:

Right. And that’s Jack Bogle of Vanguard fame, that was one of his biggest concerns. And I think why he originally, and probably even throughout the rest of his life was not crazy about Vanguard entering that space. I know one of the critiques was exactly that. So it has, for better or worse allowed a more kind of inter-day trading to be a thing that’s not really possible in the mutual fund space. For example, you’ll see a lot of traditional mutual funds that will have things in place to even restrict people trading day to day in their mutual funds.

Jared Kizer:

ETFs, there’s no way to even implement anything like that. It’s kind of trades essentially just like an individual stock does. And yes, investors are using that to think that they can reliably time markets or chase certain sectors through sector ETFs. Yeah, that’s almost certainly doing more harm than good at that point, but it is one of those structural features that ETFs have.

Tim Maurer:

It’s unbelievable to me in closing how many different investment vehicles are out there and that almost we could have some potential challenges that come with that, Jared , where investors don’t know exactly where to go in order to achieve their objectives. Is it true these days that there are more baskets of stocks out there in terms of mutual funds and ETFs than stocks themselves?

Jared Kizer:

Yeah, that’s absolutely true. And to compound that you can look at other structures that we haven’t even talked about today that are still out there and fairly prominent as well. So yeah, it’s kind of a multi-tiered world out there for investors. We’re talking today about the structure, which is literally nothing more than the wrapper, meaning it’s kind of the wrapper that the vehicle takes. And then the next level down is, well, what is the investment strategy that it’s actually implementing? So it is bewildering out there on a number of different levels and you’re right. One great stat on that is the fact that you’ll see more funds and ETFs and structures out there than there are the individual equities that trade. So that gives you a sense of how broad the marketplace is at this point.

Tim Maurer:

Well, Jared, we’re thankful to have you help guide us. And indeed, thank you for tuning into this episode of Ask Buckingham as well. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com, or by emailing your question to question@askbuckingham.com, or just clicking the corner of your screen. It’ll take you directly to the website.

Tim Maurer:

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