One of the most common misunderstandings I hear from Do-It-Yourself (DIY) investors is that mutual funds are bad while exchange-traded funds (ETFs) are good.
This oversimplification is rooted in the idea that mutual funds are expensive and actively managed, and ETFs are cheap and passively managed. And while that was once true, the investment landscape has evolved in recent years, and now active ETFs outnumber their index-tracking counterparts, although passive ETFs still have more assets under management.
Index funds, whether mutual funds or ETFs, try to replicate the investment performance of some underlying benchmark. That’s why we call them “passive” – the goal of the fund is deliver performance as close as possible to the underlying benchmark, without active decisions by the fund managers.
For example, an index fund such as the iShares Core S&P/TSX Capped Composite Index ETF (XIC) tries to replicate the performance of the S&P/TSX Capped Composite Index, which represents 95 per cent of the Canadian stock market.
On the other hand, an actively managed fund that focuses on Canadian stocks will try to beat this benchmark on a risk-adjusted basis. The fund managers use their skills, knowledge and research to choose which stocks to include in their portfolio. Because the fund managers get paid, this results in additional costs, which are passed on to investors.
Those fees, which are often more than one percentage point higher than those of an index fund, are paid regardless of how the fund manager performs. DIY investors typically want to avoid those costs, since research shows that fees and performance are negatively correlated – on average, the higher the fee, the worse the performance of the fund.
Historically, very few fund managers have outperformed their benchmarks over long periods of time. And when they have, there’s no evidence to suggest that beating a benchmark in the past is a good indicator that they will continue to do so in the future. That’s why passive index investing is becoming more popular – since 2014, passive investments have seen nearly US$8-trillion more inflows compared with active funds, globally.
But mutual funds and ETFs are simply structures that deliver an underlying investment strategy to investors, and the structure itself does not define the strategy.
To understand why the confusion surrounding mutual funds and ETFs persists, we need a brief history lesson.
Up until 1990, mutual funds were the primary way investors could easily access a diversified portfolio of stocks and bonds. That year, the world’s first ETF was launched, right here in Canada – the Toronto 35 Index Participation Fund, or TIPs.
Originally run by the Toronto Stock Exchange (TSE), it tracked the 35 largest stocks in Canada until it was merged with the iShares S&P/TSX 60 Index ETF (XIU) in 2000. ETFs have exploded in popularity since, and up until around 2008 virtually all ETFs were index funds of some sort, tracking a variety of indexes around the world.
Actively managed ETFs remained rare however, and it wasn’t until just a few years ago that they went mainstream. BlackRock predicts that active ETF assets will reach US$4-trillion globally by 2030, a more than fourfold increase from today.
According to PWL Capital Inc.’s “The Passive Vs. Active Fund Monitor (2023),” since 2014, assets of passive ETFs in Canada have grown by 4.5 times while assets of active ETFs have grown by 6.8 times. Passive ETF assets now represent 70 per cent of all Canadian ETF assets, down from 78 per cent in 2014.
In mutual funds, the division has remained more stable, with little change in the percentage of mutual fund assets split between active and passive funds over the past decade.
There are differences between mutual funds and ETFs, but it no longer has to do with the underlying investment strategy. The differences lie in the mechanics of each structure.
Mutual funds and ETFs are both pooled investments managed by professional managers. They both offer investors access to a variety of asset classes such as global stocks and bonds. But the similarities end there.
ETFs trade on stock exchanges, so are bought and sold throughout the day when stock markets are open. In most cases, you’re buying ETF shares from other investors in the open market – the ETF company is not involved. In other cases, the ETF company will create or redeem shares, meaning other shareholders of the ETF aren’t affected.
Mutual funds trade only once at the end of each day, and not on the open market. You don’t know at what price you will buy or sell, since the price is calculated after the order is placed based on the net asset value of the securities the mutual fund owns.
On average, ETF fees are lower than mutual funds. However, some active ETFs can have fees that exceed 1.50 per cent, while some index mutual funds have fees as low as 0.09 per cent.
For most Canadians, these differences are not reason enough to seek out one structure over the other. Instead, focus on aligning the underlying investment strategy with your objectives, be mindful of the costs, and don’t assume that ETFs are synonymous with index funds.
Mark McGrath is a Squamish, B.C.-based certified financial planner and associate portfolio manager with PWL Capital Inc.