The great debate: Mutual funds versus exchange traded funds

By Al Emid | August 12 2010 03:36PM

What is the best investment vehicle, a passively managed exchange-traded fund (ETF), an actively managed ETF or a mutual fund? According to a panel of investment firm executives at the Morningstar Investment Conference held in June in Toronto, these products offer certain advantages and disadvantages and advisors should embrace all three products to meet clients' needs effectively.

A passively-managed ETF closely tracks an index while an actively-managed ETF has a portfolio manager who adjusts holdings as he or she considers appropriate. In both cases, the ETF trades like a stock on the stock exchange.

While responding to a hypothetical scenario focussing on an investor in his early forties with a buy-and-hold strategy and $100,000 in a RRSP Savings, the panellists examined the pros and cons of all three investment products.

Mutual funds provide the client with a chance to beat the index, according to Tom Bradley, President and Co-Founder of Steadyhand Investment Funds. "I don't think we want to forget that," he urged the audience, terming some indices as imperfect and citing the TSX as an example.

"We think it is a very distorted index," he said, suggesting that properly-handled mutual funds will provide a smoother pattern of return, leading to client stability. "We all know how hard it is to keep clients in the extreme points in time or prevent them from getting carried away at the top."

Mr. Bradley says other advantages of mutual funds is that they provide an advisor and client with a broad array of managers and retain the decision-making in the hands of professional fund managers. "That's all they do all day."

Control and diversification
ETFs provide the investor with the kind of control that comes with owning an individual stock, but with diversification of holdings, according to Heather Pelant, Managing director and head of iShares at BlackRock Asset Management Canada, who called ETFs a hybrid of mutual fund and stock.

"How do you get a portfolio that addresses the risk, that is doing a reasonably good job of managing the cost to that client and getting them the return that they need?" she asked, pointing to ETFs as the answer.

ETFs provide a low-cost solution for such a client, said Som Seif, President of Toronto-based Guggenheim/Claymore Investments, pitting ETF costs against mutual fund management expense ratios. "I don't think that 2.5 to 3% all-in costs are the right solution for that $100,000 dollar client," he said, pointing to lower costs of ETFs at 1.5% to 1.75%.

Actively-managed ETFs provide a best-of-both worlds solution, according to Ken McCord, President of Toronto-based AlphaPro Management. These ETFs provide expert money management in the low cost ETF structure, he argued, suggesting that an active investor would choose the ETF structure over the mutual fund structure for the very same reason that the passive investor has chosen the ETF structure over the mutual fund structure.

Some mutual funds sold by Invesco Trimark's competitors charge actively-managed fees but amount to closet index funds that mimic the indices, according to company President Peter Intraligi. "If you're paying for an actively managed-fee but what you're really getting is a closet index fund, the ETF would certainly be a better solution," he said, while stressing diversification by style, asset class and geography as the number one priority for the investor.

Meanwhile, although the panel debated exchange-traded funds compared with mutual funds, a speaker at another presentation at the conference suggested a different debate underway in the United States market. Scott Burns, Director of exchange-trade, closed-end and alternative fund research in Morningstar's Chicago Office said, "The funny thing is, if you ask stock traders (in the U. S.) when ETFs will overtake mutual funds, they'll say ‘who cares?'" he said. "The real question is when will ETFs take over single securities trading," he suggested. "The reality is that actually ETFs are much closer to doing that than they are to overtaking mutual funds."