Investors can count on low cost, reliability

PUBLISHED : Sunday, 19 July, 2009, 12:00am
UPDATED : Sunday, 19 July, 2009, 12:00am

The reasons mutual fund managers dislike exchange-traded funds are the very reasons many private investors are embracing them.

Let's cut to the chase: mutual fund managers make their real money out of the very high fees they charge. ETF fees are staggeringly modest in comparison. ETF investors do not have to pay the 5 per cent of their entire investment, which is typically charged for subscriptions to mutual funds and, if they exit the funds before a specified period, they also face early redemption charges. And while ETF investors are paying as little as 0.10 per cent in management fees, mutual fund investors are coughing up an average of 1.4 per cent.

ETFs are traded like other securities - bought and sold any time when markets are open. And unlike mutual funds, whose prices are fixed once a day or less frequently, ETF prices fluctuate throughout the day. This also means ETFs can be used to short the market, though this is not a strategy for the average investor.

All these advantages of low costs and flexibility would pale into insignificance if it could be proved that mutual fund managers were able to deliver returns that justify the high fees they charge. But history shows us that in a typical year, two-thirds of these fund managers fail to deliver returns that match the movements of the underlying indices their funds are invested in. And remember, the overall return they deliver is further depressed by the fees sliced off the top - fees levied regardless of performance.

More fundamental, there is a question of investor objectives. Mutual funds, like ETFs, are largely designed for conservative investors who are loath to be active participants in the markets, let alone pick individual stocks. ETFs, incidentally, offer a wider range of market participation because they also operate in the sphere of commodities and other non-equity investments.

ETFs offer greater diversification possibilities, as their very nature is to embrace the entire investment universe of whichever index they mimic. Mutual funds require discretion and the skill of the fund managers to beat the performances of these indices and, as we have seen, most times they fail.

In Hong Kong, where 35 ETFs are listed on the local bourse, most funds track national stock exchange indices and offer exposure to everything from Vietnamese shares to the staid world of Hong Kong bonds.

Mutual fund managers argue, not without reason, that by encompassing an entire index, investors are stuck with mediocre companies alongside the stellar performers. What they have not proved over time, although there are exceptions, is that they have devised a better way of sorting the wheat from the chaff themselves.

However, we are now entering a period where ETF performance has every reason to be overshadowed by that of professional investors who are looking at an avalanche of cash waiting to re-enter the market.

But the fact that there will be a short period of opportunity for mutual fund managers to prove their worth over the technicians who run ETFs does not negate the longer-term argument for keeping well away from mutual funds and opting for low-cost and reliable investments in ETFs.

Stephen Vines is author of Market Panic: Wild Gyrations, Risk and Opportunities in Stock Markets