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Elliott Morss | October 2, 2014

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Buying Equities: Rethinking the ETF Frenzy

by Elliott R. Morss, Ph.D.

Introduction

The stock market is enough of a random walk so most small investors should not try to pick stocks. So they are left with propositions from mutual funds, ETFs, and wealth managers. I discard wealth managers because I like, as a minimum, three-year track records, and most do not have them. That leaves mutual funds and ETFs. We have all heard the arguments: ETFs are better than mutual funds because: 

  • Lower fees;
  • Can be bought and sold during market hours just like stocks
  • Mutual funds underperform the indices that represent them, so why not buy the indices?

If you read much on finance, you might think ETFs had become the investment vehicle of choice. But how pervasive have ETFs actually become? And are they better than mutual funds?

Data on ETFs and Mutual Funds

Consider first US household holdings of financial assets. Table 1 shows that the largest holding is pension funds. A large portion of pension funds is invested in mutual funds. The corporate equity category includes individual stock holdings and ETFs. The Fed does not give a separate breakout for household holdings of ETFs. But overall, it reports ETF holdings of $875 billion.

Table 1. – US Households: Financial Assets and Liabilities (bil. US$)

Description 2010 (end 3rd qtr)
Total Financial Assets 45,682
Pension Funds 12,262
Corporate Equities 7,823
Currency and Deposits 6,533
Mutual Funds 4,423
Money Market Mutual Funds 1,127
Treasury Securities 1,083
Other 12,432
   
Total Liabilities 13,942
Home Mortgages 10,125
Consumer credit 2,409
Other 1,409

Source: Federal Reserve Flow-of-Funds accounts

Table 2 provides data on both mutual funds and ETFs for the end of October 2010 as well as the change since December 2009. Mutual fund holdings still dwarf ETFs, but ETFs are growing more rapidly. Even so, the absolute growth of mutual funds over the last 10 months exceeded the growth of ETFs. The mutual fund data also reflect investors liquidating close money substitutes at the end of the bank panic to get back into equities.

Table 2. – Mutual Funds and ETFs (bil. US$)

  End Since Percent
Instrument Oct. 2010 Dec. 2009 Change
Mutual Funds
Stocks 6,053.50 455.40 8%
Bonds 2,667.60 461.40 21%
Money Market 2,786.80 -529.00 -16%
Total 11,507.90 387.70 3%
ETFs
Stocks 780.35 188.41 32%
Bonds 143.16 43.71 44%
Total 923.51 232.12 34%

Source: Investment Company Institute

Critique: ETFs versus Mutual Funds

There is no question ETFs are easier to trade and their fees are lower. On mutual funds underperforming the market, I got out a 2007 Morningstar Principia CD and made a couple of searches for funds categorized by Morningstar as domestic growth (large, mid, and small cap). How did they do relative to the S&P 500 for the three year period ending June 30, 2007? The results are presented in Table 3.

Table 3. – Domestic Growth Mutual Funds Outperforming S&P 500

  Number of Number Percent
Type Funds Outperforming S&P Outperforming
Load and No Load 3,263 906 27.8%
No Load Only 2,887 807 28.0%

Source: Morningstar Principia

Ok. 70% of mutual funds underperform the market average. But note: there were 800+ no loads that did better than the market average.

Consider a few points on ETFs.  

  • Jeff Middleswart, the manager of The Vice Fund (VICEX) pointed out to me: nearly all stock indices (foreign and domestic) are heavily weighted toward banks and real estate.  These are the areas of the market that normally trigger problems that cause market meltdowns. My recommendation – never buy an ETF without looking carefully at what equities it includes;
  • ETF excesses: the editor of a major financial web site said they are being overwhelmed by new ETF offerings, like the garden catalogue season is coming in the US: how about an ETF that includes a publicly traded wheel barrow company in Hungary with a Chinese company that makes garden tools? He said a large portion of new ETFs “never see the light of day” – someone takes a flier and if there are not enough buyers, it is not launched.

I hold both ETFs and mutual funds. If one outperforms the other for an investment area that interests me, I buy it.

  • For Latin America, I hold PRLAX. Over the last three years, it slightly outperformed S&L Latin America 40 (ILF) and significantly outperformed S&P Emerging Latin America (GML). But I also own a Brazil ETF (EWZ) because I like Brazil;
  • MINDX significantly outperformed S&P India Nifty Fifty Index (INDY), so I own MINDX;
  • MCHFX significantly outperformed iShares FTSE China 25 (FXI), but there is another issue in China – in recent years, the government has been using the local exchanges to sell off inefficient state enterprises. I am willing to pay a mutual fund fee in hopes of avoiding them.

What am I saying? In the new enthusiasm over ETFs, don’t forget the 30% of the mutual funds that outperform the market.

My complete portfolio can be seen at http://www.morssglobalfinance.com/hedging-long-positions-in-emerging-markets/.

I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell a security.

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