When are mutual funds good?

When I help investors build index portfolios they can manage on their own, one of the first steps is determining whether they would be better off with ETFs or mutual funds. Sometimes people balk at the very question. “What do you mean you’re considering mutual funds?” they’ll ask. “I keep reading mutual funds are bad. I want to use ETFs.”

There are enormous problems with the mutual fund industry in Canada: many have extremely high fees, inexcusable sales charges, lousy performance, and aggressive marketing teams. Heaven knows I’ve been beating that drum for years. But there’s an important subtlety that gets lost in this criticism: none of these serious issues has anything to do with the mutual fund structure. And once you strip away all of the rotten features, it turns out mutual funds can often be superior to ETFs. Blasphemy, I know, but bear with me.

First, there is no law of nature requiring mutual funds to be expensive. In the U.S., companies such as Vanguard and Fidelity offer index mutual funds with fees between 0.05% and 0.10%, in line with ETFs. Fund costs are much higher in Canada mainly because there is less competition and more indifference on the part of the public.

As for the poor performance of most mutual funds, the culprit is not their structure: it’s their strategy. Most active fund managers try to outperform their benchmark indexes by picking stocks and making tactical plays, and most cannot do this successfully after accounting for their fees and transaction costs. Expensive actively managed ETFs—and there are a few out there—have a track record just as unimpressive.

Unfortunately, almost all index mutual funds in Canada are far more costly than ETFs. But if you stick to the cheapest ones (TD’s e-Series funds trump all the rest) I’d argue that the mutual funds have the advantage in several areas.

They’re more user-friendly. Buying and selling ETFs is difficult for many inexperienced investors, and mistakes can be costly. You need to understand the difference between bid and ask prices, between market orders and limit orders, and other trading techniques that can be intimidating. You have to trade whole shares, so you can’t invest exact dollar amounts. You also need to trade ETFs in real time when the stock exchanges are open, which is a challenge for busy people, especially those outside the Eastern time zone. Mutual fund orders are much easier to place, since you simply enter the dollar amount you want to invest and your order is filled at the end of the business day.

Preauthorized contributions. One of the best ways to invest with discipline is to set up preauthorized contributions to a portfolio of index mutual funds. That takes much of the emotion out of your decisions. True, you can set up automatic contributions to an online brokerage account and then use that cash to buy ETFs, but you would need to enter every trade manually. Most people simply don’t have the discipline to do this.

Lower trading costs. Almost all brokerages allow you to buy and sell index mutual funds without trading commissions. By contrast, most charge about $10 to buy and sell ETFs, which can easily wipe out the advantage of the ETFs’ lower management fees if you trade too frequently. (A few brokerages offer commission-free ETFs, which definitely levels the playing field.) But that’s not the only transaction cost. ETFs, like stocks have a “bid-ask spread,” which means the price you pay when buying them is higher than what you’d receive if you sell them. This may only be one to four cents per share, but it can add up when trades are large. Mutual funds always trade at their end-of-day net asset value, which means that you avoid this additional cost.

Reinvestment of dividends. Mutual funds efficiently reinvest all dividends and interest: every cent stays in the fund and continues to compound. Most brokerages offer dividend reinvestment plans (DRIPs) on at least some ETFs, but there will always be residual amounts paid in cash each month, where they languish uninvested.

Easier record keeping. If you hold investments in a taxable account, it’s much easier to track your adjusted cost base (ACB) with mutual funds: you can even call the fund company directly to get accurate book values. This makes it easier when it comes to calculate any capital gains or losses when you sell your funds. ETFs tend to require extra effort, and many brokerages don’t do it accurately.

ETFs are definitely the best vehicles for savvy index investors with large portfolios, but they’re not right for everyone. As long as investors choose the lowest-cost options, a properly managed mutual fund portfolio can end up delivering better performance than a collection of ETFs in the hands of someone who is unable to properly build and maintain it.