ETFS Challenge Mutual Funds

Posted: Sep 25, 2008 12:01 AM

Let's get ready to rumble.

In one corner is the mutual fund, time-honored champion of small investors. In the other corner a fast-rising challenger, the exchange-traded fund.

They are fighting for your investor dollar. Some experts predict the ETF will ultimately win the long-term confrontation.

"In a year such as 2008 when returns are low or negative, every 50 basis points (half of a percentage point) make a difference," said Tom Anderson, head of ETF research at State Street Global Advisors, Boston. "Because ETF fees on average are dramatically lower than those of mutual funds, the difference is huge."

ETFs, which hold baskets of stocks or bonds as mutual funds do, replicate market indexes or sectors with the goal of low-cost diversification. They're traded on an exchange so you can buy and sell during market hours, unlike a mutual fund in which you trade shares at the end of the day. Although you must pay to trade ETFs, annual fees are generally lower than even index mutual funds.

"A number of value-oriented ETFs have done astoundingly better than active mutual fund value managers this year," said Ronald DeLegge, publisher and editor of in San Diego. "While in theory the active manager can raise cash and protect capital, that hasn't been working out because some top value managers are performing badly."

DeLegge noted that while the SPDR Dow Jones Large Cap Value ETF (ELV) is down 14 percent this year, the actively managed Legg Mason Value Trust (LMVTX) is down 28 percent.

This has been a somewhat perverse year, with the top-performing mutual fund and ETF both bear-market funds that bet on the market going down. The mutual fund ProFunds UltraShort International (UXPIX) is up 42 percent this year. In ETFs, the UltraShort MSCI EAFE ProShares (EFU) is up 40 percent.

In some ways, comparing mutual funds to ETFs is apples to oranges.

There is a buyer for every ETF seller because they are traded on exchanges, so an ETF doesn't have to scramble to sell holdings to meet a rush of shareholder redemptions as mutual funds sometimes do. No minimum initial investment is required with an ETF and there are no penalties for redeeming shares. Dividends are paid in cash, rather than reinvested as in a mutual fund. And annual fees are lower.

An ETF strong point has been ability to quickly add specialties, being done from commodities to solar energy to foreign currencies.

Many investors still have no exposure to commodities, which is obtained most easily with ETFs, DeLegge said. Examples are iShares GSCI Commodity-Indexed Trust (GSG), up 15 percent this year, or PowerShares DB Commodity Index Tracking Fund (DBC), up 20 percent.

"If you're looking for active money management, ETFs in their current form aren't there yet," said Scott Burns, director of ETF analysis at Morningstar Inc. "But if you're looking to index or to allocate to a sector or to access commodities or other asset classes that were once hard to reach, ETFs can be a suitable investment."

Hottest current examples are so-called "quantitative active" ETFs, which operate on a quantitative model in their selection process much as many hedge funds do, Burns said.

Two of the oldest successful examples of quantitative active ETFs are PowerShares Dynamic Large Cap Value ETF (PWV), with a three-year annualized return of 6 percent, and PowerShares Dynamic Mid Cap Growth ETF (PWJ), with a three-year annualized return of 8 percent. Both keep their expenses low.

The weak U.S. dollar has popularized those ETFs with international focus this year, Anderson said. Between the SPDR DB International Government Inflation-Protected Bond ETF (WIP) and the SPDR Lehman International Treasury Bond ETF (BWX) more than $1 billion in new money has been invested, he said.

When considering the competition between ETFs and mutual funds in a difficult year for investing in general, one must not overlook the might of the long-standing champ. The mutual fund has gained vast acceptance, including through 401(k) company retirement plans.

"There are over 700 ETFs with just under $600 million in assets, compared to about 8,000 mutual funds with $11 trillion in assets," Anderson said. "It will therefore be a long while yet before one can realistically talk about ETFs becoming bigger than mutual funds."

ETFs represent not only a way to invest in broad market indexes, but a chance to pick up intriguing specialties.

"This year it largely hasn't mattered if you were in an ETF or a mutual fund, but rather what asset class you were invested in," Anderson said. "Money moved into commodities and bonds has done well this year, while you got hammered if you stuck with international or U.S. equities."

Never forget that it is the underlying investment, rather than the vehicle, that always decides results. Style, such as value or growth, makes a difference.

"One thing investors tend not to understand is the concept of style investing, because they tend to compare everything to the S&P 500," said DeLegge, who considers it important to have a reliable benchmark to which you can compare your holdings. "Investors must understand that a small-cap value fund should be compared to a small-cap value index, not just to a small-cap index."