While it’s not wise to change your entire mutual fund investment strategy based on recent performance, it may be time to consider some alternatives like ETFs.
For mutual fund investors, 2007 and 2008 were brutal years. First it was the large capital gains distributions in 2007, then it was the terrible performance in 2008. In many ways, mutual funds are coming up short from the standpoints of taxes, performance and expenses.
If mutual funds are flawed, what are the alternatives? Consider exchange traded funds. There are now hundreds of ETFs, ranging from broad-based market-tracking ETFs to sector-specific holdings.
Even though the investment community promotes mutual funds for long-term investing, portfolio managers often don’t act that way. Many mutual funds have turnover exceeding 100% of their portfolios each year. The substantial trading can create additional capital gains distributions, which erode the investor’s returns.
In addition to annual tax costs from turnover, advisers can be surprised with legacy tax costs. Funds could go for a number of years with little to no gains, and then distribute substantial gains, based on the sale of long-term holdings.
The problem is that a client may not have been an investor in the fund during the years when many of those gains occurred. Basically, such clients are paying taxes on gains never received.
From an investment standpoint, mutual fund managers have some explaining to do. Pick a fund, any fund, and go to its website. Likely there will be an explanation of its investment strategy, which the managers will say is disciplined and designed to control risk.
In 2008, however, things didn’t quite work out as planned. According to the January issue of the Journal of Financial Planning, about 68% of actively managed, large-cap mutual funds failed to beat the S&P 500 stock index last year. Moreover, a number of prominent funds that had good long-term track records fell apart in the second half of the year.
At times, fund managers can become so consumed by beating an index or staying wedded to one philosophy that their judgment becomes clouded. This can lead them to take excessive risks that result in excessive losses.
Given that investors generally feel a loss three times more keenly than they do a gain, a fund that fails at least to match its benchmark can be a serious problem from a business standpoint. Over the last few years, far too many advisers found themselves apologizing for a fund’s performance.
From an expense standpoint, mutual funds pose a problem, too. If funds are tax-inefficient and fail to produce returns that exceed their benchmarks, then why pay for active management?
Investors can lower investment costs by at least 0.5 to 0.75 percentage points by using low-cost ETFs instead of mutual funds. All else being equal, this is a positive addition to a client’s long-term returns. What’s more, ETFs are often highly tax-efficient because investors have their own cost basis in the shares they own.
Turnover is generally quite low, as most ETFs track established market indexes. This means the annual distributions are usually small and the client won’t be saddled with legacy tax costs. Lower tax costs generally mean a higher net return for clients.
And finally, during bear markets, investors are not burdened with surprises. Broad-market ETFs have a very low tracking error and tremendous transparency. Therefore, advisers know what they’re getting. This can be incredibly important during times of economic crisis. Advisers need to know what clients own so that they can effectively manage portfolio risks.
When it comes to creating portfolios, advisers may better spend their time studying index and ETF construction than searching for the “best in breed” manager.
There are, of course, many good mutual fund managers. It is just hard to identify them with any degree of consistency, and sometimes good managers make mistakes. Given current conditions, this may be a good time to hedge bets with some passive indexing that is low-cost, tax-efficient and transparent.
