Three attributes that clearly differentiate ETFs from most mutual funds

By John DeGoey, Vice President and Portfolio Manager
Burgeonvest Bick Securities Ltd. 

I’ve been using exchange-traded funds in my practice for well over a decade and I have to admit there have been some really interesting advances in the world of product development over that time. There are now literally hundreds of ETF offerings in Canada that provide investors and advisers with the opportunity to express their opinions on any number of sectors, asset classes, currencies and strategies. The ability to engage in granular portfolio construction with purposeful tax optimization – including tax loss harvesting – is all but total.

My point to readers, however, is that just because you’ve got all these whiz-bang tools doesn’t necessarily mean you ought to feel compelled to use them. The main reasons I use ETFs today are the same reasons that I gravitated toward them back in 2001: asset class purity, tax effectiveness and low cost. Taken together, these three attributes are what clearly differentiate ETFs from most mutual funds on the market today. 

Asset class purity is important. In fact, research led by Gary Brinson shows that asset allocation is by far the largest determinant of risk in a client’s portfolio. It stands to reason that if you delegate elements of the asset allocation decision to someone who might, at their discretion, use different asset classes in managing their investment products, you may very well lose control over your asset allocation.

Tax effectiveness is determined largely by portfolio turnover. Many (possibly even most) ETFs have an average annual turnover of less than 10 per cent (i.e., a holding period of over 10 years). In contrast, most mutual funds have a turnover rate that is substantially higher, with a large amount over 50 per cent (i.e., a holding period of less than two years). Quite apart from the obvious trading costs and philosophical questions (is a person who holds for less than two years an investor or a speculator?), it should be obvious that the more actively traded product will likely incur much higher taxes. Note that this is only relevant in taxable accounts.

Finally, there’s cost. My experience is that most ETFs cost about 1 per cent less than F class (i.e. no advisor compensation) mutual funds with a similar to identical mandate – and a penny saved is a penny earned. Therefore, if you simply switched from standard mutual funds to ETFs, you would likely save about 1 per cent in annual costs. The absolute dollar amount in annual savings would increase over time as your account grew with market trends. Depending on your age, savings rate and current account size, the amount of savings could add many years’ worth of lifestyle expenses to your nest egg. 

Research done by Standard and Poor’s (feel free to Google ‘SPIVA’) shows that the majority of active funds consistently fail to beat their benchmark. Meanwhile, there have been numerous studies, beginning with Mark Carhart’s research published in 1997, that have shown that past performance does not persist and that it is not possible to reliably pick winning funds in advance.
All told, and in my opinion, the benefits of ETFs in comparison to standard mutual funds are stark.  Deciding which way to go makes for a really simple decision.

John J. De Goey, CFP, CIM, fellow of FPSC is a Vice President and Portfolio Manager at BBSL. The views expressed are not necessarily shared by BBSL, CEFTA, ETF World magazine or the publisher. john.degoey@bbsl.ca