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Planning for Retirement

How to Choose The Right Investment Portfolio Container: Mutual Funds vs Exchange Traded Funds

Clock5 min. read
byJohn Guttormson onJune 28, 2020

Investment expert and seasoned industry pro John Guttormson weighs the pros and cons of mutual funds and exchange traded funds, so you can make an educated choice when it comes to investment portfolios.

Investment container explainer: it's like paper vs plastic

When looking out your window at the snow-covered world in early spring, it might be tough to imagine that in just a few months, many golf courses will be opening. The rivers will be abandoning their frozen form and crews will begin their spring cleanup.

Those crews might debate what type of container to use for the seasonal flotsam they collect. Paper or plastic? Bags or boxes? Each have their pros and cons — cost, convenience and recyclability. In the same way, the investment world also offers choices of containers, or portfolio delivery systems.

Mutual funds & ETFs: The Beatles & The Rolling Stones of diversified investments

Although there are a variety of investment portfolio containers to choose from, the most two most prevalent forms continue to be:

  • mutual funds, the most widely-used investment portfolio container, and

  • exchange traded funds (ETFs), the low-cost darling of the investment world lately.

In 2018, almost $500 billion was taken out of a vast array of mutual funds around the world. Conversely, ETFs increased their value by almost exactly the same amount.

History of mutual funds

Mutual funds were first designed for clients seeking diversification without the capital necessary to own a range of individual securities. Clients bought units of a mutual fund portfolio to achieve broader asset allocation. In the early days of mutual funds, it was not uncommon for an investor to pay an upfront fee of 8% fee for the privilege of owning this solution.    

Commonly-held beliefs about investment portfolio containers

Most investors, when asked to describe the differences between these two containers, will respond that:

  • mutual funds represent the active management of a market segment, and

  • ETFs passively duplicate a market index.

They also believe ETFs to be far less expensive than mutual funds. Both are sold by prospectus as the offering document.

The truth about ETFs versus mutual funds

In terms of total client dollars invested in ETFs, it is mostly an accurate assumption that ETFs cost less than mutual funds.

However, there are important differences:

  • Mutual funds can also be managed to achieve an index return (we will leave the term ‘closet indexer’ for another day)

  • ETFs are now actively managed with the intention of outperforming a given benchmark or peer group.

Some strategies are actually available as both mutual funds and ETFs. 

What to watch for

It is absolutely critical investors recognize that the growing number of ETFs, as the container of choice, also include increasingly complex approaches to investing. For example, there are reverse leverage ETFs, which bet against the market and utilize ‘leverage’ or borrowing tactics that can generate big wins or potentially catastrophic losses for the investor. Caveat emptor!

Further, mutual funds which have a range of embedded fees do not have a separate cost for purchasing or selling units. The “T” in ETF stands for traded, and every trade has a cost.

Expert advice: understand the risks and the unknowns

Not long ago, Jack Bogle, the father of passive investing, and founder of industry giant Vanguard Investments, passed away. Following his retirement, Vanguard introduced ETFs, a decision Bogle regularly criticized. In particular, his concern was the high frequency (rebalancing) trading and potential to cause  and also be affected by significant volatility both within a given day and over the course of a market cycle.

Former US Secretary of Defense Donald Rumsfeld is remembered for his quote describing “unknown unknowns”. What Rumsfeld meant was you don’t know what you don’t know. And what we don’t know about ETFs is how they will be affected — or affect the market — especially with the unprecedented volatility being experienced almost hourly as the COVID-19 virus' global impact is updated. Why? Simply because there is little experience to go by. Not unlike the phenomenon on negative interest rates that evolved only four years ago.

Conclusion: do your homework and talk to an experienced advisor

When it comes to deciding between mutual funds and ETFs, being informed and well-advised is critical. Read as much as you can in advance, and when you're ready, find a financial advisor with the experience you need to make the best choice.

Doesn’t the decision whether to use paper or plastic seem much simpler now? If you'll excuse me, I've got to go find my rake.

John Guttormson is Principal at 50North Consulting in Winnipeg, a company focussed on investment performance management. A long time investment and financial services industry insider, he was previously a founding partner at Richardson Partners Financial Limited (now Richardson Wealth) and Senior Vice President of Product at Investors Group (now IG Wealth Management). John also hosts a weekly radio show on UMFM called Bang and Whisper and teaches entrepreneurship at a local college.

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