ETFs vs. Mutual Funds

by Mike Holman

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Recently, Rob Carrick of the Globe and Mail wrote an article in which he compares Canadian equity mutual funds to the iShares Canadian Composite Index Fund (XIC) in terms of performance over the last five years. He discovered that only five mutual funds out of about 100 beat the ETF.

Funds which beat XIC in the last five years:

  1. Acuity All Cap 30 Canadian Equity
  2. imaxx Canadian Equity Growth
  3. Altafund Investment Corp.
  4. TD Canadian Equity
  5. TD Canadian Equity-A

While I would argue that you really need a longer time period and varying conditions (ie bear market) to determine if ETFs are superior to mutual funds, this study raises some interesting questions. If you have an investment advisor who tells you that they can pick top performing mutual fund managers then I would suggest you take a look this list of Canadian equity funds and if you don’t see anything familiar then maybe you should ask your advisor why they didn’t pick one of the top funds. Another good question to ask yourself is why you even need an advisor if you can pick a standard ETF and get better performance.

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One of the big benefits of Exchange Traded Funds (ETFs) are the lower management costs which are typically less than 0.5% when compared to mutual funds which normally charge anywhere from about 1.3% to 3% for equity funds. Books such as Four Pillars of Investing and Random Walk Down Wall Street emphasize the fact that these lower costs result in better returns for ETF. Only a minority of mutual funds will beat their index in any given year and the problem is that very few of those funds can continue to beat the index for any length of time. Over time, broad market ETFs will beat the vast majority of mutual funds which makes it very difficult to pick the rare fund that does better than an ETF.

The problem we have as consumers is that we never see any advertising which promote ETFs (since they are low cost after all) but we get bombarded with ads from financial companies which always boast about one or two of their funds which have had superior performance in a recent time period. What you need to figure out is how many funds those companies manage and how many are they advertising? It’s usually a small percentage.

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{ 9 comments… read them below or add one }

1 Mr. Cheap

Its always good to remind ourselves of ETF / Index Fund performance and how no one will advertise it to us…

I guess if Canadian Large Caps have been out-performing the index as a whole over the last 5 years that it might be a good time to by Canadian small caps…

2 FourPillars

Yay, a comment! :)

I personally think the US market is the best one to get into at the moment – the market has taken a few hits, the US$ has dropped – what better time to buy?

Mike

3 moneygardener

Would be great to see a comparison when markets/resources perform poorly. I think we may see more mutual funds outperform.

4 FourPillars

MG – I would agree that if there is a big correction – since most mutual funds have at least a small cash holding that should cushion the fall a bit.

I guess the relevant comparison is one that is long term and covers all different kinds of market conditions.

Mike

5 moneygardener

Another point is that XIC is much too heavily weighted in resources/materials. This is inherently riskier and more cyclical than a mutual fund that has a more balanced asset allocation. The Canadian market can be a dangerous one to index IMO.

6 Four Pillars

MG – that’s an excellent point as well which I conveniently didn’t mention in the post.

I personally have diversified out of Canada for this very reason. It hasn’t paid off over the last year (which is when I did it) but I know it will pay off in the long run.

Mike

7 Cross the River

One must remember that the rate of return should not be the only element considered when comparing ETFs to mutul funds. You also have to consider the commission for the purchuse of the ETFs. In order to minimize the overall cost, one should keep etgfs for the longest period of time possible.

PS: great blog!

8 Mr. Cheap

Good point CtR… thanks!

9 HS

Just to continue CtR’s point, if someone was to DCA (Dollar Cost Average), it could be very expensive if they were investing into ETFs. Thats because ETFs are purchased from brokerage. Even if you’re at a discount or low-cost brokerage, you’re still paying per transaction. Even if you’re paying $10/transaction (most brokerages in Canada are charging a lot more then that), and you’re doing a monthly contribution, then thats $120/year, which could negate (and then some) the difference between the fees between Mutual Funds and ETFs.

Also keep note that when you conduct a buy/sell order, you have to pay ‘spread’ – the price at which you can buy is slightly higher then the price at which you can sell. Whoever is executing the trade in the stock market for you is pocketing the difference.

Another point, is that ETFs are not professionally managed, and you’re not getting professional advice from an advisor or mutual fund manager. This means that you have to do all your own homework and spend the time and energy to look through vast selection of ETFs available. Most people don’t have this time of time, patience, or understanding capability, so investing in an ETF ‘might’ not be for them.

Every strategy has its pros and cons, and both should be analysed before making ANY financial decision.

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