Mutual Funds Vs ETFs
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Zach – Hey everyone, Zach Holcomb here again with Michael Reese, Certified Financial Planner, with this week’s blog. Today’s topic, we’re talking all about mutual funds versus ETFs. Mike, I know you have a lot of great insight on this topic today.
Michael – Oh yeah, mutual funds versus ETFs, it’s a big conversation. And you know, it’s really kind of interesting, Zach, because if you were to go out and ask the man on the street or the woman on the street, and you said, you found a hundred of them and you asked them, “Hey, what’s the difference between a mutual fund “and an ETF?”, I would suspect that the vast majority couldn’t even tell you what an ETF is and what it stands for. It stands for, by the way, Exchange Traded Fund. So they can’t even tell you what it is, and when it comes to the difference, you’re probably going to get a lot of blank stares, right? But this is really important because historically mutual funds have been kind of the tool of choice, if you will, when it comes to investing money. And more and more today we’re seeing where ETFs or exchange traded funds are completely replacing, almost eliminating, what is now known almost as the old fashioned mutual fund. So I think this is a good topic to help really identify the difference between them.
Zach – Gotcha, okay. So kind of take us back a little bit about the history of the mutual fund, how that got started, and why that was such a popular tool for years.
Michael – Oh, sure, that’s a great question. Here’s what happened historically. Way back when the stock market used to be really only. for the rich, the wealthy or the big institutions. The average person on the street, they were not invested in the stock market at all. And, I think back in the late ’20s when the, we all know about the Great Depression and the stock market crash of 1929, I think that there was like 8% of the population was even invested in the market anyway, so that didn’t really affect, the market losses didn’t affect the average person. In fact, it affected wealthy people. Now, what did affect the average person? The banks closing, there was no FDIC back then, and the economy going into a shambles, but not the stock market. So what Wall Street wanted to do is, they were trying to think how can we get the average person to invest in what we’re selling, which are stocks? And an enterprising individual, who I don’t know their name, but somewhere around 1926, and then especially as we got into the ’40s and beyond, they started coming up with this idea of a mutual fund. And the idea was that everybody could chip in a little bit of money, we could pool together assets. So like you, Zach, you could kick in $50. I could kick in $50 and we could get a thousand other people kicking in $50. And before you know it we’ve got enough money as a group to buy a diversified stock portfolio. So this fund would have a manager who would identify which stocks to buy or which bonds to buy. And that manager would build a diversified portfolio and we would all get some fractional ownership of that portfolio. So it was a really nice way for the average person to start participating in the markets. And then along come the ’70s where IRAs and 401ks were born. And the next thing you know, mutual funds were the perfect tool to go into a 401k. And shazzam, it’s like the world exploded. And suddenly everybody is now into mutual funds. Everybody’s invested in the market because mutual funds made it easy for them to do so.
Zach – So it sounds like mutual funds had it going on. It sounds like, I mean, they’re great all around, but are there any negatives or cons to using mutual funds?
Michael – Yeah, as you get the, as you can imagine, mutual funds, they do have a number of advantages and disadvantages. And before I dive into the cons, I actually wrote down a few of the advantages here to make sure that I didn’t miss any. What’s kind of nice about mutual funds is, number one, they are, for the most part, diversified. They allow you as a small investor to essentially play with the big boys, right? Invest like the big boys. You can buy into a diversified portfolio that’s professionally managed with really small amounts of money. A lot of times, 25 or $50 a month, perhaps, might be all you need. The minimums to get in tend to be quite low. You get that professional management, but also you can set up automatic deposits, automatic withdrawals when you’re retired. They’re pretty flexible tools to use. And they’ve really stood the test of time for many, many years. Of course, though, they do have, as you were asking a minute ago, they have a number of disadvantages. And when I look at these disadvantages, as a financial advisor, the disadvantages do drive me crazy. I have to say that, they drive me crazy. And the number one disadvantage, by the way, I hope all of you don’t mind, but I’ve just been visited by one of our dogs in the office. If you see my background waving, that’s a tail wagging. Apparently it’s my turn to pet the dog. Anyway, some of the disadvantages, number one disadvantage that drives me crazy, it’s a black box. There’s no transparency or very little transparency. So what happens is when you invest in a mutual fund, Zach, you get one of these prospectuses. Have you ever read one of these prospectuses?
Zach – I have not.
Michael – Okay, they’re these huge, huge, legally written documents. They’re really not easy to read. And what they do is they basically outline, first they tell you yes, you can lose money, which we all know, but they lay out, what’s the purpose of this fund? Oh, it’s to invest in stocks. Okay, great, what kind of stocks? U.S. stocks, international stocks, big companies, small companies, some mix of each? So it lays out kind of what they’re investing in. That’s straightforward enough. But then they list the fees that they charge. And there could be a number of fees. There could be management fees and 12b-1 fees, all these different fees. And you would think on the surface, you’re like, okay, that’s cool, that’s the fee structure. But remember this is a black box, so here’s the problem. You don’t know exactly what you’re invested in. So every six months, like two times a year, they give you a report and they give you a list of here’s all the stocks that we own. But it’s a list of at that point in time. These guys are buying and selling every day, right? So by the time you get that report, half the stuff in that list is already gone and they’ve replaced it with something else. Next, there are additional fees that they charge you behind the scenes, and you’ll never ever, ever, ever, ever know what they are. You’ll never know what they are. They’re completely hidden, drives me crazy. Another disadvantage, you can only trade these things at the end of the day. So if you’re someone that you’re working and you’re just doing like dollar cost averaging and you’re saying every month I put in my $50, my $100, my $200, it’s not a big deal. It goes in and it gets invested, but you never know exactly the price that you’re buying at because you don’t know until the end of the day. And so you get whatever the price is at the end of that day. But if you’re trying to manage a portfolio and you’re trying to say, look, I want to invest at this point, you can’t do that with a mutual fund. Further, you can’t sell. All you can do is you could say is today I want to sell my fund. Okay, what price am I going to sell at? I don’t know, there’s no way to know. You don’t know until the day is over and they price out what the fund is worth. And then you sell what you want to sell. And so it’s like I buy at the end of the day, sell at the end of day. So I don’t know exactly what I’m paying these guys. I don’t know exactly what I own. And I don’t know the price at which I invest at or sell at until after the fact, I can’t control that at all. And then the other big disadvantage is if you are in an after-tax account. So that would be like not an IRA or not a 401k. So it’s like money, you saved some money on the side, you’ve invested it, maybe you got an inheritance, maybe you sold some real estate or something, you invested it. If you invest that money in mutual funds, every year they spin off a 1099. Zach, do we have any idea what the interest in dividends are going to be for the year? No.
Zach – No idea.
Michael – It’s like hey, next year comes, you get your 1099 at hopefully the end of January and surprise, here’s what you get. There are years in which you lose money in your account yet you owe a whole bunch of tax as though you made money. There are years in which you make a bunch of money, but you don’t owe much tax at all. So a lot of times it’s kind of, the tax rules are very, very strange. So while mutual funds do have a lot of benefits, at the same time they have a large number of disadvantages.
Zach – It seems like the cons kind of outweigh the pros in a lot of ways.
Michael – Well, it depends on where you’re at in life and what you’re trying to do. If you’re the average person and you’re just trying to save money in your 401k, these mutual funds work great. They work great for 401ks. They’re just chugging right along. They are really built, just so that you know, mutual funds, they are built for growth and accumulation. That is what they are built to do. So yeah, there are pros, but I’m just commenting that as a professional, the disadvantages do drive a person crazy in my position because I hate black boxes. I crave transparency. The more transparent something is the better job I can do for clients and the better job I can do with investing their money when I have transparency on my side versus a black box.
Zach – Right, so let’s take the opportunity here to pivot, Mike, since the topic today is mutual funds versus ETFs. A lot of people don’t know what an ETF is so let’s kind of explain the history of that, how that became very relevant in our world.
Michael – Oh sure, an E-T-F, that’s an acronym, it stands for exchange traded fund, and there, that tells you everything you need to know, right, Zach? Are we all done? No, I mean probably when I say ETF and then I say exchange traded funds, if you’re like most people, you’re like, you’re thinking, you scratch your head like wait a minute. You told me nothing there, Mike. I now know maybe less than when I started. Basically here’s what happens. In the mutual fund space, there is a company that came out, I think it was 1976 or somewhere in the ’70s, there was a company that started by Jack Bogle called Vanguard. A lot of people have heard of Vanguard, and Vanguard is famous for creating the concept of what are called index funds. An index fund is where you are intentionally just trying to duplicate some stock market index or bond market index. An example is the S&P 500. A lot of people have heard of the S&P 500. It is essentially the 500 largest companies in the U.S. stock market. And so a lot of people say that, and that represents about 85% of the stock market. And a lot of people say, boy, if I could just hold that, those 500 companies, that’d be great. But if you can imagine trying to go out and buy those 500 companies individually, not so easy to do. So Vanguard comes along and they say, tell you what, we’ll create a mutual fund where that’s what we do. We essentially buy all 500 companies. And that way we will duplicate that part of the market for you. And if you want small companies, there’s another index called the Russell 2000. We’ll buy those, we’ll create an index, a mutual fund to buy those. And so this gave financial advisors and individuals more control over what they were investing in, a little more transparency. But here’s the thing. Do you think Vanguard for the S&P 500 Fund, did they really buy all 500 companies?
Zach – Probably not.
Michael – No, they buy like 300 of them and they call it good enough, it’s close enough. Do they really buy 2,000, all 2000 of the Russell 2000 companies? No, they buy maybe 1,200 of them or something. But the point is, they’re not perfect yet. They’re just getting closer to being better. And what was nice about them, an index fund, is there’s less trading so the costs are, there’s more transparency. Again, it’s not perfect, it’s better. So an exchange traded fund concept came along because they were, people were saying, now, wait a minute, we like what Vanguard’s doing here, but we think we can take it a step further because we still have the same problems. We still have some tax issues. We still have, we can’t, we can only buy it or sell it at the end of the day. By the way, you can’t write an option on these to protect your position. Still a bunch of disadvantages. We want it to be better. We want to have a mutual fund that allows us to buy and sell during the day. We want to be able to maybe sell call options or buy put options against it to hedge or protect our position. we want to have full transparency and we want the fees to go down to almost nothing. And so what an exchange traded fund is, it is essentially the next generation of these index funds where nowadays you can get an exchange traded fund on almost any index you could think of. There’s even exchange traded funds on the gold index. Instead of owning gold personally, you can just own the index, the exchange trade fund, GLD. And the idea behind them is, just like a mutual fund, a lot of your average, average people can invest in these things, just like a mutual fund you can have small dollar amounts. Just like a mutual fund you can do automatic investing and automatic distributions. Just like a mutual fund we’re diversified. But what has happened with exchange traded funds is they’ve basically gone down the list of the disadvantages of mutual funds and they’ve kind of ticked them off one by one and said let’s get rid of that disadvantage one by one. So for examples, I looked through this, a disadvantage of a mutual fund is it’s a black box. We don’t really know what we own at any point in time. And we don’t know what we pay at any point in time exactly. Well, what does an ETF do? They say, no, we’re going to give you full transparency. If you have an S&P 500 ETF, you literally own all 500 companies in exactly the right proportion. And the fees, the fees are told right upfront. Here’s what the fees are. They tend to be very like incredibly cheap, almost free, but here’s what the fees are and that’s it. There are no other fees, there’s nothing hidden, everything fully transparent. I’m like, oh, that’s great. As an investment professional, that’s great. I love that, I love being able to, I want to know what I pay, I want to know what I own. What’s another one here? Oh, this trading idea. It only trades at the end of the day. No, ETF you can buy and sell it all day long, just like a stock. And what’s really important is if I want to invest, let’s say I want to invest client money in the S&P 500, if I use a mutual fund at Vanguard, I just say at Vanguard, I pick the day I want to invest and whatever the price is at the end of the day, that’s what I get. With an ETF, on the other hand, I can put in what’s called limit orders where I could say only invest when the price gets down to this point, so I get to actually pick the price at which we invest the money. I could do that with an ETF, I can’t do that with a mutual fund. The same is true if we want to sell. We use a lot of algorithms that determine when do we want to buy and when do we want to sell? And a lot of those algorithms, they even give us buy points and sell points. If we can get those numbers, it’s ideal. So we can put in those limit orders. Do you know that with a mutual fund I can’t put a stop loss order in? But I can with an ETF. So what does that mean? That means I buy an ETF at this number, and I could say, if it ever goes down to this number, just sell it out. Don’t call me, don’t send me an email and say, hey, what do you want to do? Just automatically get me out of that position. That’s called a stop loss, I can do that with an ETF. I can’t do that with a mutual fund. So fully transparent, so I don’t have that problem. Trading, I can buy, sell during the day. I can do options on exchange traded funds. I can say, I can sell a call option. That’s like writing covered calls. I can buy a put option to protect against the downside. It’s like buying insurance on your portfolio. You can do this with ETFs. So there’s a lot more options available, or a lot more opportunities available with an ETF, that we don’t have with a mutual fund. And from a tax perspective, ETFs really allow us to control our tax outcomes. Like a stock, I can pick and choose. I can do tax loss harvesting, I can choose when to buy, when to sell. So essentially what’s happening here is ETFs are kind of, they’re taken the great concept of a mutual fund. By the way, mutual funds, wonderful concept. They’ve taken that wonderful concept and they said, all right, just like in computer programs, Zach. Like an iPhone, remember our first iPhone that came out?
Zach – Oh, it’s so primitive now.
Michael – But do you remember what was the next iPhone called?
Zach – The S, was it the S?
Michael – Oh my gosh, you are so young, It was like the iPhone 2 and the iPhone 3. This was all probably before you were born. It wasn’t that long ago, but now we just saw, what are they doing? The iPhone 12.
Zach – Yeah.
Michael – Apple is now on their 12th iteration of iPhones. Do you think the iPhone 12 is better than the very first iPhone that came out?
Zach – Oh yeah, absolutely.
Michael – Yeah, of course it is. Just like that, ETFs are kind of like mutual funds 5.0. Or they’ve iterated it now where it’s like, it’s just the newer version of mutual funds. That’s all it is. And these exchange traded funds. It’s been like five years since I’ve, now, by the way, I’m going to say this, there are still a few mutual funds that we do use. I find that mutual funds today are really ideally used in the fixed income space, the bonds. Some bond mutual fund managers, they’re truly adding value and they’re delivering better returns. They are definitely delivering better returns than their benchmarks. But outside of that, in the stock market space, we haven’t used a mutual fund in years. We’ve gone to ETFs completely because it’s just a more efficient, more transparent way of doing the same thing. So it’s kind of like the newer, cooler version. And by the way, I think I’ll point this out. The whole industry is moving to that, if you even look at Vanguard, go to Vanguard and say hey, Vanguard, when’s the last time you’ve released a new mutual fund? It’s been years since they’ve released another fund and they’re hardly ever releasing new mutual funds. But if you say, hey, Vanguard, when’s the last ETF that you’ve released? Vanguard’s producing ETFs like crazy. It seems like every year they’re pushing out more and more ETFs. Vanguard is transitioning away from mutual funds to ETFs. So is, Fidelity, Schwab. That’s what the industry is doing. And if you think about it, there’s no reason not to. It is the, it’s just progress, that’s all it is. So mutual funds kind of the old fashioned way of doing things. A great idea, but they’re all being replaced with ETFs. ETFs are the wave of the future.
Zach – All right, well it’s crazy how this transition happened. It seems like so quickly, like you said, kind of five years, it was really the big transition from mutual funds to ETFs in our industry, correct?
Michael – Yeah, it’s about that time ago. And you know, today it’s just, it’s proliferate. I mean, it’s all over the place. It’s kinda like this, I think about, as we kind of wrap up today, I think about how when I was in high school, I remember that driving, like if I went somewhere, my friends, my best friend’s car, he had an older car. And in that car, Zach, he had, and this is something I’m sure you have no idea what it is. It was an eight track player, like one of these eight track cassette players. And the big, the big technological advancement happening when I was in high school was the birth of the cassette tape. And, oh my gosh, cassette tapes were awesome because they were smaller, like these eight track tapes and they’re huge and bulky. But a cassette, it was smaller and you just popped it in. Oh, it was awesome, it was just wonderful. Except they kept getting caught in the tape deck and you had to get a pencil to wind it back up. And then after that came the CD. I remember going to the music store and there were albums, like real vinyl albums. And then we got cassettes and then there were CDs and that replaced everything. And yet if you buy a new car today, a lot of them don’t even have CD players in them because everybody’s listening to either Sirius XM or whatever that is.
Zach – Everything’s digital now.
Michael – Or they plugged their iPhones or their cell phones into their car and they’re listening to something on their phone. The point is technology helps us move forward. And it seems like it goes faster and faster. That’s where we are right now, ETFs are the future. And there really aren’t a lot of disadvantages with ETFs. I think we might’ve hit the perfect version here. I don’t know, maybe I’m missing something and it’ll change in the future, probably will, but that’s where we’re at today. And so, anyway, I hope this whole discussion was helpful for all of you. And remember, we’re big believers that your best is yet to come and we look forward to helping you enjoy that great retirement. So with that, Zach, it was great talking to you today. Any final thoughts from you?
Zach – This was very insightful for me, I learned a lot.
Michael – Alright, that’s it, take care, everybody.
Zach – Thanks everyone, bye.