3 Mega Advantages of ETFs over Mutual Funds
Ron DeLegge, Editor
July 5, 2010
SAN DIEGO (ETFguide.com) Ė In sports, competitors look for any little advantage over their rivals and exploit it to their gain. Even a small advantage can often mean the difference between victory and defeat.
Investing is the same way. Investors should look for a competitive edge and use it for their gain, so long as theyíre not breaking the rules.
Itís no secret that exchange-traded funds, also known as ETFs have many significant advantages over traditional mutual funds. ETFs are index funds that trade like stocks. Yet, the bulk of investors still arenít maximizing these advantages to their gain.
Letís analyze three mega-advantages of ETFs over mutual funds.
People that understand the risk of losing a valuable asset like a home, a life or a car buy insurance. But why donít they do the same thing with their other valuable assets, like their investment portfolio? Why donít they buy insurance?
One reason is because they canít. With traditional stock or bond mutual funds, thereís no protection for your money from major declines in the market. Asset allocation and diversification can certainly help, but they have their limits.
On the other hand, ETF investors can buy insurance on their investments via protective put options.
For example, a position in the SPDR Gold Trust (NYSEArca: GLD) can be hedged by owning puts. Any decline in GLD would be offset by a corresponding gain in GLDís put options. Why? Because put options rise in value when the assets linked to them fall in value. This kind of financial flexibility and protection isnít afforded to people that invest in gold mutual funds or even physical gold.
Sure the cost of buying insurance or put options is money out of your pocket but it can give you peace of mind.
A Thing Called Liquidity
Highly liquid investments can quickly be converted to cash, whereas less liquid investments require more time. Oddly, liquidity is one of the most underrated cornerstones of a good investment plan. In fact, liquidity is so important that a lack of it has driven multibillion enterprises completely out of business. (See Bear Stearns, Lehman Brothers and a boatload of others.)
Because ETFs offer investors intraday liquidity whereas mutual funds donít, the former is a better choice for investors that care about financial flexibility.
Imagine if you went to buy a hammer at Home Depot at 10 A.M. in the morning and then tried to exit the store 15 minutes later, but something strange happened; store managers wonít let you leave the store until closing time at 9 P.M.! How would that make you feel? Do you think it would mess up your plans for that day? Now just think about how the same type of onerous restrictions could mess up your lifetime investment plan!
Hereís what it means: So long as the stock market is open for business, ETFs can be bought and sold throughout the day. This kind of intraday liquidity is a significant advantage, especially when market precise trades, portfolio rebalancing and raising cash quickly matters most. On the other hand, mutual funds are bought and redeemed once a day at their NAV price Ė a competitive disadvantage.
Fees, Fees, and Fees
Mutual fund managers are sometimes maligned for making the wrong investments, but even the best fund managers consistently underperform versus index ETFs. Why?
The competitive advantage of ETFs over mutual fund boils down to lower costs.
Across all major investment categories, from bonds (NYSEArca: AGG) to international stocks (NYSEArca: EFA) and real estate (NYSEArca: RWR), ETFs have substantially lower fees. This in turn, boosts bottom line performance results! ďYou'd better keep investment costs down so you aren't overwhelmed by the tyranny of compounding costs, whatever market return you might get,Ē stated John Bogle, author of Common Sense on Mutual Funds (Wiley 2010).
This is the kind of uncooperative market and economic climate where the odds of investment success have been turned against investors.
Yet, for all the advantages that ETFs have over mutual funds, the aloof masses still prefer mutual funds. At the end of May, there was just $788 billion invested in ETFs compared to a whopping $10.70 trillion invested in mutual funds.
Will mutual fund investors ever learn?
For their sake, letís hope so.