ETFs vs. Mutual Funds: The Debate Rages On

An exchange-traded fund (ETF) is most simply described as a mutual fund that trades like a stock.

At the core of this vehicle is a basket of underlying securities that seeks to replicate an index or trading strategy that the ETF sponsor has produced.

The first ETF ever created was the SPDR S&P 500 ETF (NYSE:SPY) which was launched back in 1993. Since that time, there have been a number of evolutions in the financial services industry that have seen ETFs grow exponentially.

ETFs are touted for a number of reasons. In most cases, they charge a fraction of the annual expense fees when compared to the average open-ended mutual fund. They are also extremely transparent and offer intra-day liquidity that mutual funds cant compete with. The majority of ETFs are passively managed which means that they track an established index and rarely have portfolio turnover. This limits the impact of capital gains and makes them tax-efficient as well.

ETFs are continuing to be adopted at a rapid clip as cost-conscious investors look to trade their fee-heavy mutual funds for sleeker investment vehicles. In the U.S. alone, there is currently over $1.6 trillion spread among more than 1,500 funds with momentum increasing every month. In addition, ETF sponsors are continuing to produce innovative index strategies to compete with the more traditional actively managed mutual fund space.

Detractors of ETFs point out that the proliferation of funds in the marketplace makes them hard to distinguish between each other. In addition, the ability to get in and out of the market at any given time may ultimately work against some investors that are unable to keep pace with stock returns.

There are also a number of innovative trading strategies or asset allocation models that mutual funds employ that have not yet been replicated in an ETF format. A handful of active mutual fund managers, particularly in the fixed-income arena, have proven that they can offer superior returns. Fund strategies from the likes of PIMCO, DoubleLine, and Loomis Sayles have all beat their benchmarks over respectable time frames and have offered their investors either excess income, risk management, or superior security selection.

On the equity side of the ledger, adding excess return through active management has proven to be more elusive than simply following a passive index. This continues to be one of the primary drivers for asset flows to equity-oriented ETFs that I expect will continue for the foreseeable future.

At the end of the day, there is no one size fits all investment vehicle that you can point to with unequivocal conviction. Each individual will likely invest in a combination of individual securities, mutual funds, and ETFs at some point in their life time. The key to success is knowing what you own and why you own it so that you stay informed on the best mix for your unique situation.