Why ETFs have displaced mutual funds as a portfolio mainstay

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John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.

Many investors may not be aware, but the idea of an exchanged traded fund was originally conceived by the U.S. Securities and Exchange Commission in response to the 1987 stock market crash.

The idea for an ETF-like vehicle, which was labelled a "market basket instrument," was discussed by the SEC as a way to buffer the equity market from the futures market, writes Eric Balchunas in his book The Institutional ETF Toolbox. As Mr. Balchunas points out, "the U.S. government had a hand in inventing the ETF."

While it may have taken a decade or two for ETFs to get out of the gate, they are quickly displacing mutual funds as the mainstay of the average investor's portfolio because of the many benefits they offer. Those include: lower fees, liquidity, transparency, tax efficiency and access to various market exposures.

Both ETFs and mutual funds are baskets of securities, like stocks, designed to follow a certain strategy. Much of the money invested in ETFs track an index, like the Standard & Poor's 500, and there are mutual funds that do the same. But many mutual funds are managed by someone who is actively selecting stocks for the portfolio aiming to beat the benchmark, and, as readers of this column know, it is very difficult to find active fund managers, in advance, who have long track records of success and don't charge exorbitant fees.

Many active managers failed to keep up with the 12-per-cent gain in the S&P 500 last year, which was fuelled by a post-election rally. When the markets are on a tear, it becomes harder and harder for stock pickers to win.

Tracking a multi-year trend, Morningstar says investors pulled $340-billion from actively managed equity funds last year and poured $504-billion into passive strategies, which would include ETFs. That far outpaced the previous record inflow amount set in 2014.

According to Morningstar, investors took $263-billion from active U.S. equity strategies last year, more than double the amount in 2008 when the financial crisis. Active U.S. funds haven't seen a full year of money flowing in to them since 2005. Some of that money most likely went straight into plain vanilla index fund ETFs, but another growing area in ETFs is strategic beta funds or factor strategies, which combine the advantages and with tilts toward stocks that possess certain investment characteristics (i.e. value or momentum).

ETFs accomplish the same goal as mutual funds – pooling money from mom and pop investors to give them access to professional management and diversification -- only ETFs do so at a lower cost and lower minimum investment thresholds, another reason why they have become so popular.

They also have important differences in how they are traded and taxed that may make ETFs more attractive to some investors.

To start with, an ETF trades throughout the day and its price fluctuates with demand and supply. An investor who wants to cash out can do so at any time, but may get a different price than another investor cashing out at a different time and might trigger trading commissions. Mutual funds, on the other hand, are bought and sold at the end of the day, when their prices are set. Investors selling or buying them pay the same price.

ETFs are more tax-efficient, however. When a mutual fund investor wants her money back, the manager may be forced to sell portfolio holdings to pay for that redemption. Any capital gains from that portfolio turnover are shared by investors at the end of the year regardless of when they bought into the fund. With an ETF, an investor's capital gains are measured between the price of the fund when it was bought and the price at which it was sold. If it isn't sold, there isn't a tax.

One of the biggest benefits of ETF investing is the diversification. They allow exposure to broad indexes, sectors of the market like small cap or large cap stocks, regions of the world, countries, and even specific niches like gold or retailers. This feature of ETFs makes it easy to build a broadly diverse portfolio using a handful of ETFs that track different benchmarks. Automated advisory firms have drawn investors eager for this type of quick and simple investment diversification.

They have forced fees in the investment industry lower, too. The average U.S. equity mutual fund charges a little over 1 per cent a year, but that is lower than a few years ago. ETFs on average charge about half that, and some much lower.

It's also easier for an investor to evaluate what the ETF portfolio is holding at any given time. Mutual funds only report their holdings every three months, with a built-in time delay like other professional managers. Mutual funds have leeway to stray from their investment objective, which can mess up an investor's allocation model. In contrast, an ETF can report its holdings more frequently and because it tracks an index as closely as possible – there are an army of behind the scenes traders on Wall Street who make money buying and selling securities that keep the price very close to the net asset value of the underlying fund holdings.

ETFs can't solve every problem, however, and in my next column I will discuss some of the potential downsides for ETFs and investors. But for most part, it's hard to argue that ETFs have changed the game in lowering costs and making investing easier.