Considering ETF Investing and Mutual Funds

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This is a guest post by Neal Frankle.  He blogs over at Wealth Pilgrim about how to find balance in your financial life.  When you finish reading, please consider signing up for his daily posts?

ETFs – better than mutual funds?

Mike Piper recently wrote a great piece on ETF investing right here at Debt Free Adventure.  In it, he did a super job explaining how they work and how they differ from index funds.  If you’re like me, you’ve been reading quite a bit lately about ETFs and why they are or are not better than mutual funds.

Mike makes the argument that since most mutual funds fail to outperform the index, you should buy the index – and the way for you to buy the index is to buy an ETF that matches the index as closely as possible.  Mike’s argument is very strong.  Having said that, I think there is a very important issue that often gets lost in this discussion.  As I see it, the “ETFs versus mutual funds” is a tactical issue.  An important tactical issue… but a tactical issue none-the-less.

What concerns me is that folks sometimes make dogmatic decisions about this (and other issues) and fail to consider strategy – and all the alternatives.  Here’s what I mean.  If your strategy is “buy and hold” – the argument to buy the least cost/better performing vehicle makes all the sense in the world; but what if you aren’t content to “buy and hold”?  What if you use a investment strategy like market timing? (Oh, I said it… “market timing”. Bad Pilgrim… very bad Pilgrim!)  Believe it or not there are market timing strategies that work.

A case for mutual funds over ETFs

There are millions of people who make money buying stocks – some of which are not buying and holding.  There are huge numbers of people who buy funds that are in (what they identify as) stronger areas of the market and refrain from investing in other areas that are weak.  There is evidence to support that this strategy can make sense for the right investor. It doesn’t work perfectly, nothing does… but it may be a better fit for investors who want to try to avoid some of the risk and are willing to give up some of the gains.  It would be silly for those using this strategy to ignore mutual funds and only use ETFs.  Why?  Let me give you an example…

One strategy ranks all the funds according to their short-term performance (1 year.)  This strategy doesn’t care about expenses, but is actually focused on performance.  Since performance is net of fees, it doesn’t really matter what the funds charge investors so long as, at the end of the day the performance is good.

You can see how using this strategy can make ignoring mutual funds outright a silly decision.

It’s sort of like the people who ran baseball in the 30’s and 40’s.  They ignored an entire population because of race considerations.  As soon as the sport welcomed African Americans on to the field, the performance sky rocketed.

What is your investment strategy?

Well… are you ignoring an entire population of funds at your own expense?  Do you struggle with the decision?  Do you dismiss mutual funds outright because of the expense and tax issue?  Let us know…



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1 Mike Piper

Hi Neal. Thanks for writing a reply article.

For what it’s worth, our strategies are not so different as you think.

Your strategy relies on short-term market momentum.
My strategy (buy & rebalance–often called “buy & hold”) relies on intermediate-term mean reversion.

Momentum and mean reversion are really just two sides of the same coin. One can’t exist without the other. (William Bernstein does a better job explaining it than I ever could.)

2 Neal

Cool Mike. I just love doggin’ you man…..

3 BG

My investment strategy is to put everything into a Vanguard Target Retirement fund: one stop shopping for stocks & bonds, brain-dead easy, you get the market averages (whatever they may be), and is age-appropriate since the fund becomes more conservative over time. I have my 401(k) and IRAs all in the same TR fund…

4 Derek Clark

I’m actually one of those crazy guys who thinks it is ok to invest in single stocks. I’ll admit that it is actually probably a terrible idea for most people, because most just aren’t as interested as I am. That being said, the market as a whole, and most mutual funds have really sucked for the last decade, but there are a lot of companies that did really well (see apple).

While I know there will be losers, I am fairly confident that with lots of study you can pick stocks and beat the market. I had the bad fortune to decide to start investing in October of 2007, but I have done pretty well with the little bit I have invested during one of the toughest times to invest in a long time.

5 BG

Derek: if you are going to spend the time researching companies, then may I suggest you place your bets using options (instead of just purchasing the stocks out-right). Your bets will be 100x stronger with the same capital investment — just be sure that you are not wrong.

🙂

6 Derek Clark

Actually I do a little of both. I really like the flexibility options give you. I only do deep in the money though (or at least fairly deep). That way you are not as likely to lose all of your capital. out of the money is enticing, but then it becomes huge market timing as opposed to just leverage.

I lost money with the only out of the money options I tried, but I’ve done really well using in the money. You can buy big stable companies and make 20-50% on like a 3% move.

7 Monevator

Hi Neal,

I’d have thought if you were market timing then ETFs are preferable to mutual funds. They’re far more liquid. Funds you have to go through a whole palava to get your money in and out. ETFs are just a couple of clicks.

Where even passive mutual funds are still definitely preferable for many is for regular savings of small amounts of money, since buying small quantities of ETFs can be expensive.

8 CLAUDE CLOUTHIIER

STATUS: Age:83. Income: $2000 US SS Mo….. Portfolios: Mutual Funds: $85.0 in US, $185.0 CN …..Reside in Canada, 90% spending in Canada from income. Debt: Mortgage – $$700 mo plus taxes, condo expenses $$600 mo.

PROBLEM: What to maximize income value, portfolio considering future value of US dollar exchange rates, taxes, inflation

GOAL: Primary: Maintain monthly spending requirements without drawing from Canadian assets. Secondary: Achieve reasonable net growth and provide for possible 10 year needs..

QUESTION: If allowed, should I invest further in US with US required fund disbursements ($300 yr.) or in Canada after exchange?. Would EFT’s better assist in Goals? US or Canadian?

Respectfully

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