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Debunking 4 common myths advisers have about mutual funds

With rising ETF popularity, some have written off mutual funds, but advisers need to understand the nuances

Dec 4, 2015 @ 10:21 am

By Michael Iachini

Mutual funds aren't getting nearly as much attention as ETFs these days. It's ironic because mutual funds continue to be enormously popular with investors and advisers, and remain some of the most widely-owned investment products in the world. ETFs are newer and growing rapidly, so — understandably — that's going to prompt a lot of attention. The low profile mutual funds have these days has led to the circulation of various myths and misconceptions, so let's get some facts straight.

Myth #1: The mutual fund is dead.

Let's put the big one on the table first. In the age of ascendant ETFs and robo-advisers, some investors have written off mutual funds as irrelevant. But keep in mind that mutual funds still hold over $15 trillion in assets, more than seven times the size of the US ETF market.

Part of the huge mutual fund asset base is due to the dominance of mutual funds inside 401(k) plans. ETF options in these retirement accounts are still limited. Another part of the dominance is due to the prevalence of active management in mutual funds, which is still rare in ETFs. For investors and advisers who want to try to beat the market, mutual funds offer far more options with longer track records.

Keep in mind that active management isn't an all-or-nothing decision, either. Many investors and advisers lean on active management in categories that they see as less-efficient such as small cap or emerging market stocks, or where the indexes have unattractive characteristics (e.g. bond indexes being dominated by the most-indebted issuers). In other categories, they may lean more toward indexing, or a combination of the two. If active management is involved, mutual funds likely have a role.

(More insight: ETFs becoming a key portfolio staple)

Myth #2: ETFs are always the better choice.

Many investors and advisers love ETFs, and for good reason: They make it easy to get diversified exposure to a wide range of asset classes with flexible trading, generally at a low cost.

But what if an investor or adviser doesn't want the stress of trading? For those folks, knowing that assets are either going to work, or coming out of the market at exactly the fund's daily net asset value per share (instead of having to worry about whether you're paying more or receiving less than the net asset value), is pretty attractive, which traditional mutual funds deliver. It's great to have the ability to pick your point during the trading day to jump in or out of an ETF, but this means you have to make a timing decision, pay attention to bid-ask spreads, decide on a limit price (you are using limit orders with ETFs, right?), and so on. Not everyone wants to deal with the challenges of trading.

Myth #3: Mutual funds are expensive.

You can absolutely pay a ridiculous annual expense ratio when you buy certain mutual funds… but most investors don't. The investing public has gotten smart, and when they choose to buy a mutual fund they generally buy the lower-cost options.

Source: Morningstar data as of 9/30/2015; calculations by Charles Schwab Investment Advisory, Inc.

If you look at the funds investors and advisers are actually buying, you'll see that most of their money is going into lower-cost options. The average expense ratio for all 26,000 mutual fund share classes that Morningstar has data for as of September 2015 is over 1.2%, but if you weight the expenses by the assets in each of those share classes (so the funds with more money get more weight), you see that average cut nearly in half.

(Related read: Advisers flock to an ETF that costs more than a mutual fund)

Furthermore, expenses for mutual funds have been coming down steadily for 10 years; on an asset-weighted basis, they've been coming down steadily for 20 years.

Source: Morningstar data as of September 30 each year; calculations by Charles Schwab Investment Advisory, Inc.

Mutual funds are a lot more inexpensive than they used to be, thanks in part to competition from ETFs.

Myth #4: The Morningstar rating is a good way to pick a fund.

Some investors and advisers love easy-to-understand star ratings from Morningstar, and many of them gravitate toward funds with four- or five-star ratings. But star ratings are a simple ranking of past performance, adjusted for risk; they're not inherently forward-looking.

Source: Morningstar data as of 9/30/15; calculations by Charles Schwab Investment Advisory, Inc.

Above, you'll see the result of picking funds based on star ratings. For each month, beginning in February 2003, we tracked the funds that received each of the five possible star ratings and then compared the performance of those funds to the median fund in the corresponding Morningstar category over the next three years. The chart shows you the percentage of funds of each rating that did better than that median category peer over the next three years.

Sometimes, such as the periods ending in 2006 and 2007, five-star rated funds far outperformed their lower-star counterparts. But when markets get choppy, as they did starting in 2008, the performance gap disappears; one-star funds did just as well as five-star. And if you look at the performance of funds that were rated at the end of 2008 (during the credit crisis) and follow them through the end of 2011, you'll see that the one-star funds did the absolute best of all and the five-star funds did the worst. When markets change direction, the stars lead you astray.

Just picking based on the stars is not a recipe for success. You need to evaluate a fund based not solely on past performance, but also expenses, the fund family, the assets in the fund and more.

None of this is to suggest that mutual funds are better than ETFs, or vice versa. Every investment choice comes with its own specific set of criteria and circumstances. Investors and advisers need to know the nuances that different solutions deliver in order to make good decisions. And part of that is knowing how to separate fact from fiction.

Michael Iachini is managing director at Charles Schwab Investment Advisory, overseeing research into mutual funds and ETFs.

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