How to answer young investors’ questions about ETFs

Here I share their questions and my answers so you can understand what young investors need to know about ETFs.

Q: I understand that mutual funds are essentially a basket of stocks or bonds managed by a fund manager and bought as a whole for a fee. My understanding of ETFs is pretty similar, but I know they’re different. So what is the difference between an ETF and mutual funds?

A: Mutual funds have been around for a long time, and many investors understand that they are a diversified basket of stocks, bonds, and other securities managed by a fund manager. Mutual funds have become a popular way for investors to diversify their holdings with the help of an experienced money manager.

A mutual fund manager selects stocks and bonds that meet the fund’s mandate. The fund charges a management fee which, together with the operating fees, results in a management expense ratio (MER). The MER can be between 0.5% and 1.5%, sometimes even more. Bond funds typically have lower MERs than stock or equity funds.

Mutual funds are bought at market close, when all the underlying stocks have settled. ETFs, on the other hand, are traded on an exchange and can be bought and sold as prices change throughout the day.

The first ETF was launched in Canada in 1990 and used what is known as “passive management”. The goal of passive management is to simply replicate the performance of a large index with a basket of stocks that is rebalanced regularly. ETFs can now be either passively or actively managed (see below) and use algorithms or rules to track a specific index. As a result, they tend to have lower MERs than comparable mutual funds.

With mutual funds, a fund manager is hired to add “alpha” to the fund’s return through something called “active management,” also known as excess return. This active return generated by the manager should exceed the calculated MER, but this is not always the case.

For example, industry reports such as S&P Indices Versus Active (SPIVA) have long shown that most actively managed funds underperform the index they are compared to (known as a “benchmark”). According to the most recent SPIVA report for Canada, between 57% and 95% of Canadian mutual funds have underperformed their indices over the past 10 years.

Q: If mutual funds don’t outperform, why use ETFs instead?

A: I started using passively managed ETFs after the Great Recession of 2008-2009. After reviewing industry statistics like the SPIVA reports, I realized that most active mutual fund managers weren’t adding alpha to their funds’ performance, only additional fees.

Because of their structure, ETFs offer a diversified, lower-cost alternative to actively managed mutual funds. Bond ETFs typically have a lower MER than stock ETFs.

I decided I wouldn’t pay a premium for a mutual fund manager unless I had a very good chance of beating the index that the manager was using as a benchmark.

Q: Can a mutual fund compare to an index or does that make it an ETF?

A: Whether you use an ETF or a mutual fund to invest, you need a benchmark to let people know how well you’re doing your job. As mentioned, this is called a benchmark.

As I previously illustrated with the results of the SPIVA report, a US equity fund manager compares his return to an index comparable to his portfolio composition. In this case, the S&P 500 is a suitable benchmark for US stocks.

A mutual fund manager generally does not attempt to replicate its benchmark index. Instead, they use their stock-picking skills to select what they believe are the best stocks in their index universe. They will use the benchmark index to illustrate how much alpha they are generating.

If the manager can demonstrate that its returns and stock-picking methodology consistently outperforms the index net of fees and possibly with fewer ups and downs (“up and down” is referred to as volatility), then the manager has good reason , to attract investors in the fund. If the results aren’t convincing, an investor may prefer to choose a better-performing mutual fund or an ETF that passively tracks the mutual fund’s benchmark index. As previously mentioned, such an ETF is the return of the index minus fees.

The same logic applies to bond funds. Investors can choose between a bond fund or a bond ETF, or a combination of both.

In our next installment of our Q&A with Meghan, we’ll tackle questions about using ETFs in portfolio construction.