It’s clear that many investors have a pre-conceived notion that ETFs are a better way to invest than open-ended mutual funds. But is this really true?, asks Jack Bowers, editor of Fidelity Monitor & Insight.
Let’s break it down:
• Trading Flexibility. ETFs have a clear advantage here, because you can buy and sell during market hours at the next available price or use specified limits. And because they trade like stocks, you can buy on margin or sell them short.
Mutual funds, in contrast, can only be purchased or sold (without leverage) at the day’s closing price, and often come with minimum holding periods (in Fidelity’s case 30 days).
• Expenses. Here it depends on the investment type. Fidelity’s index funds generally have lower expense ratios than most ETFs that track the same benchmark. Actively run Selects are a mixed bag versus comparable ETFs.
But when it comes to active ETFs that mimic their own funds (including equity and bond offerings), costs tend to be slightly lower. For example, Blue Chip Growth the mutual fund has a 0.79% expense ratio versus Blue Chip Growth the ETF which is 0.59%.
• Trading Cost. Open end mutual funds have a clear advantage here, because no-load shares are bought and sold directly through the mutual fund company at net asset value.
With ETFs, you are using the secondary market, which usually means paying a little more than net asset value when you buy, and getting a little less than net asset value when you sell. Even if the transaction is commission-free, this pricing spread can wipe away any advantage that might come from a lower expense ratio.
• Range Of Investment Choices. Here again it de-pends on what you’re after. ETFs have the advantage when it comes to indexing or making focused bets on commodities, specific countries or regions, or unusual asset classes.
Some even come with built-in leverage for the “high rollers.” In contrast, mutual funds tend to offer a more diverse range of choices when it comes to domestic stocks or bonds. Fidelity’s Select family, for example, covers a wide range of domestic industry groups.
• Taxes. When it comes to hold-ing a passive ETF versus an index mutual fund, there is essentially no difference in tax liability.
On the active side, ETFs do have the potential to keep capital gain distributions lower during the holding period, but that “advantage” only lasts until you sell the position, at which point you pay more tax than the active mutual fund. In the end it’s a wash.
There are lots of ways to achieve tax-efficiency (that’s a topic for a future column), but none of them require the use of ETFs.
• Performance. Suppose you construct two portfolios — one using ETFs and another using open-end mutual funds — with identical underlying holdings and a mix of active and passive holdings.
The ETF portfolio is likely to have a slight advantage from an expense ratio stand-point and a slight disadvantage in trading cost due to the buy/sell pricing spread. Assuming normal portfolio turnover, there will be no significant difference in long-term performance.
• Model Portfolio Logistics. Relative to a mutual fund portfolio, tracking and reporting for an ETF model portfolio is more challenging because of a 3-day delay in determining distribution reinvestment prices. On top of that, the trading dynamics for an ETF model portfolio are more error-prone.
Because anyone following an ETF model must place trades with-out limits and buy/sell only on the day’s close, there would be many more cases where trades are placed incorrectly and many more situations where performance deviations occur.
In the end, it’s really the investment strategy that determines whether ETFs or open-end mutual funds make the most sense. For strategies that demand high-turnover, elevated risk levels, and ac-cess to obscure asset classes, ETFs are the only way to go.
On the other hand, a low-turnover strategy that does not involve market timing is likely to be better served by open-ended mutual funds — especially if it is a model portfolio that many will be trying to follow. As such, we will not be introducing ETF versions of our model portfolios.
For those who insist on an ETF strategy, it is possible to substitute Fidelity’s sector ETFs for the VIP positions in our Annuity Sector Model (which is restricted to the 10 basic sector choices in Fidelity’s annuity lineup). But this is not something we recommend because we don’t see any long-term ad-vantage in it.