Studying for securities exams makes me think of investment and securities all the time. One thing that came repeatedly to my mind is that if everyone builds a productive portfolio of life, everyone’s life would be drastically different. And when everyone life changes to the better, the whole country or even the entire world would be better.
I will write another blog comparing financial and life portfolios later. For now, let’s focus on financial or investment portfolio first and consider a trillion dollar question of how to compare mutual funds and Exchange Traded Funds (ETFs). If you are an investor, or an investment advisor (aka financial planner), you simply cannot bypass these two products. One way or the other, today or tomorrow, you will likely use either or both of them and recommend them to your clients. We might as well dig deep into them and have a decent understanding of both. Note when I say mutual funds, I am mainly considering open ended mutual funds, the most common breed of the management investment companies.
The idea behind financial portfolios
But first, what exactly is a portfolio? According to this article on Investopedia, “A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents, including closed-end funds and exchange traded funds (ETFs).” More generally, “A portfolio may contain a wide range of assets including real estate, art, and private investments.”
The idea behind using portfolios to reach financial well-being is simple: we want to gather, accumulate and manage a sufficient, diverse and dynamic mix of financial resources to get to where we want to be.
Why do diverse and dynamic resources matter? In finance and in investment, the thinking is basically about reducing risks. It has been proven time and again that putting one’s asset eggs in different baskets is always better than putting them all in a single basket. This is just common sense: Would you jump into an important project without having a Plan B? If the answer is “No,” then a portfolio is just like your Plan B in investment, plus Plans C, D, E or F or more. With a portfolio, you do not have to bet — and then pray — for everything to work out as Plan A says, because you know you have options. If one option does not work out, you go after others.
Portfolio & risks
A portfolio is very effective in cutting down the so called “non-systematic risk” arising from narrowly investing in one particular asset class (e.g., all stocks, or all bonds, or all money market, all real estate, all commodities). Similarly, investing in one industry or one sector of economy tends to drive up the same non-systematic risks.
What about systematic risks, the crisis that hits the entire market or entire economy? Traditional wisdom says a diverse portfolio does not help with systematic risk. Chinese has a good way of saying or describing it: When the whole nest egg is flipped over and falls down from a big tree, no one expects to see an unbroken egg (覆巢之下焉得完卵).
But that may no longer be true. For one thing, we can now have a global portfolio containing assets across borders, which does help us reduce systematic risk involving an entire economy. Even within a country different sectors have different risk exposures. Utilities or more generally the “defensive industries” like foods and pharmacies can do well in good and bad times. Using the same Chinese metaphor, when a nest of eggs falls from a big tree, different eggs will land at different times or places. It is possible to see one or a few unbroken eggs after all.
No single winning portfolio
One thing about financial portfolios is that there is not a single winning portfolio for everyone. What is good for one may not be good for another. It depends on one’s preferences, goals and risk tolerances. Another factor is people’s life stages. At younger ages, people can afford to be aggressive and risk tolerant. When they get older toward retirement ages, they have to be more conservative. This means portfolio realignment is a common and smart approach for working with new goals and priorities. While diversity is always good at all ages, priority can differ over lifetime.
New ways of establishing diversity
While diversification is always considered a virtue in investment, how to achieve diversity evolves over time. In the old days when the Investment Company Act of 1940 was written, investors had to get their money together into a pool in order to reach a diversity portfolio. That is, although each investor had little money, say each only had $1 to invest, forming unit investment trust (UITs) and management investment companies (chiefly the open ended mutual funds) allows thousands or millions of investors to gather their financial resources into a “joint account,” which then established a diverse portfolio — even though each investor only had $1 to invest. The hypothetical $1 from an investor named John or Joe is effectively split into numerous projects or firms. Some may only get one cent from John, some five cents, and the lucky one may get 25 cents, but never the whole dollar of John.
This is all nice and well, which explains why after (2021 – 1940) = 81 years the Investment Company Act of 1940 is still functioning like it was first written. By the way, I often find myself admiring the wisdom of some old laws lasting such a long time in real life.
But life goes on and that old approach of pooling money from numerous investors for a diverse portfolio is no longer the only game in town. A viable alternative is to embed diversity in financial products such as Exchange Traded Funds or ETFs for short. Both mutual funds and ETFs have been referred to as “pooled fund investing” by this article, although such a notion has overlooked subtle but important differences between the two as we see below.
Comparing mutual funds & ETFs
This article from Investopedia explains the differences and similarities between mutual funds and ETFs. Although both contain a mix of securities and assets, there are differences like passive (ETFs) versus active (mutual funds) management, higher (mutual funds) versus lower (ETFs) minimum investments and operating costs, with (mutual fund) versus without (ETF) charging 12b-1 fee, investors trading shares with the fund (mutual funds) versus with other investors (ETFs) and price determined by market supply and demand (ETFs) versus calculated daily at the end of trading day (mutual fund).
Another article from the US News summarizes that “The biggest difference between index ETFs and index funds is how they trade.” That is, “ETFs trade on an exchange like individual stocks, while mutual funds do not,” as one investment expert in New York put it.
Pooling across investors vs pooling across securities
But to me, trading method or venue is not the largest difference that an ETF has made. The most important difference is that with ETFs, an individual investor no longer has to belong to an “investment club” of a mutual fund in order to achieve diversification of investment. He or she can stay independent, standing alone by him- or herself and still achieve diverse investment. The way to do that is to invest in financial products that have diversity embedded in it, and ETFs stand out in that perspective.
To be sure, a mutual fund portfolio has diversity embedded in it as well, but that diversity is achieved by tying up people’s money together into a pool to get economy of scale on the demand side, while an ETF reaches diversity by pooling stocks or other securities on the supply side.
Think of how important an expanded or growing membership base is to an (open-ended) mutual fund: There is no limit on the number of shares the fund can issue, and new shares are constantly issued to new investors. On the other hand, each investor can trade ETF just like an individual stock — but unlike stock because a single ETF is packed up with securities or bonds. Therefore, a single share of ETF is no longer one company’s stock but a composite of many underlying stocks or securities, once again pooling resources on the supply side.
Different units of investment
With ETFs, the unit or agent of investment is individual investor, while with mutual funds, it is a group of investors. The essential story with all mutual funds is to pool the money into one portfolio, reaching the economy of scale available only to large institutional investors. The investors are treated as a single account holder with undivided interest in that single portfolio. They are tied to one giant account and one giant portfolio.
This holds no matter how big a mutual fund is (e.g., the biggest mutual fund Vanguard Total Stock Market Index Fund Admiral Shares VTSAX with an AUM or Asset Under Management of $921.4 billion, almost one trillion dollars and covers more than 3,590 stocks according to Investopedia). Each mutual fund is a huge basket with thousands of eggs in it but still one basket. And sure, mutual funds will change or adjust its portfolio from time to time, but they cannot do that too frequently due to cost concerns, as portfolio turnover raises additional expenses for the funds.
Independence of investors is the key advantage
With ETFs, each investor is independent, and each enjoys freedom to the extent each can buy and sell shares of an ETF throughout the day just like trading a stock. To be sure, each ETF is also one single portfolio just like one mutual fund is, but unlike mutual fund, investors are not tied to one portfolio and more importantly, not to a group of other investors. They can trade with each other directly, unlike in a mutual fund that everything must go through the fund manager.
To the extent each ETF investor is allowed to be in and out of the ETF on an intraday trading basis and to trade with each other, each possesses a different and unique portfolio of his or her own at any particular point of time. When Morgan sells 50 shares of one ETF while Finley buys 50 shares, Morgan and Finley have different portfolios.
Because ETFs are not exclusive investment membership clubs like mutual funds are, each investor’s portfolio constantly changes and differs from others even within a single ETF, and there is no such a thing as a “shared portfolio” among shareholders of the same ETF, unlike the investment set in lockstep within a mutual fund.
Sometimes investors pay an unintended price for being in the same club. The same Investopedia article offers a real life scenario: “suppose an investor redeems $50,000 from a traditional Standard & Poor’s 500 Index (S&P 500) fund. To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund.” The reason, as this article explains it, is that “mutual funds trade directly through the fund manager, the manager may need to sell shares of the fund’s investments to generate cash needed to cover redemptions. This causes mutual funds to buy and sell within the fund more frequently than ETFs. And every time the trades generate net capital gains within the fund, it creates a taxable event for investors.” In other words, the investor is literally dragged into paying capital gain tax not incurred by him- or herself, even for those who may have an unrealized loss on the overall mutual fund investment. ETFs would not have the problem as “ETF investors are taxed on any capital gains only when they sell their shares.”
In sum, ETFs offer a liberated way for an individual to join the market directly as him- or herself, rather than as a member of a big group of investors. Having direct control over one’s own investment is a good thing — at least to advanced or accredited investors. Individuals of high net worth, meaning asset valued at least $1 million excluding primary residence, are willing to hire financial planners to help them manage wealth independently.
Is ETF the future of investment?
According to the Investopedia article, “there were 8,059 mutual funds with a total of $17.71 trillion in assets as of Dec. 2018. That’s compared to the ICI’s research on ETFs, which reported a total of 1,988 ETFs with $3.37 trillion in combined assets for the same period.” The article from US News also quotes that “according to Morningstar. The company’s fund flows report for 2020 found that ETFs had record inflows of $502 billion for the calendar year, while mutual funds saw record outflows of $289 billion.”
My main point of this blog is not to claim that ETFs represent the future of investment product. I believe mutual funds still have advantages over ETFs, especially for lower end, small and inexperienced investors. For one thing, having professional managers picking up securities for them is safter than doing investment DIY. Having an economy of scale in the size of portfolio outweighs the benefits from independence of investment operations. This article of Investopedia has discussed flaws of ETFs.
Having said that, I do believe for the younger generations ETFs may suit their needs and wants better than mutual funds. This is the same trend with option trading overtaking stock trading like this article from Quartz tells us. “By one measure, options activity in the US is on track to exceed that of the stock market for the first time: The average daily notional value of traded single-stock options has risen to more than $450 billion this year, compared with about $405 billion for stocks, according to CBOE Global Markets data.” Young investors tend to have a limited accumulation of wealth but are turned on by “slick trading apps and social-media hype.” Possessing an independent investment account that allows them control over investment activities should prove appealing to them.