Glasses of water

Selecting Investments: Mutual Funds vs. ETFs

Glasses of water

The roots of Index Fund Advisors trace back to when its founder, Mark Hebner, helped an old friend's widow take control of her financial future. To this day, everyone who works here -- advisors, portfolio managers, analysts, retirement specialists and operations staff -- are required to act as fiduciaries. That means client interests must come first, not our own.

As part of such a strict ethical standard, nobody at IFA is allowed to accept outside compensation. Our recommendations are delivered to investors as unbiased advice, grounded solely in each client's unique long-term financial goals. (See the video below from the movie "Index Funds: The 12-Step Recovery Program for Active Investors.")

Such a fiduciary culture drives an objective investment management process that starts with thorough research. This involves identifying key academic findings and monitoring studies using the broadest sets of data possible.

"Statisticians require data from periods of at least 30 years to minimize the sampling error of short-term data and to provide a more reliable estimate of expected returns and risk," notes Hebner in his book examining the academic and scientific underpinnings of IFA's passive investment strategy.

Unfortunately, he adds "very few managers are able to provide 30 years of data to their clients."

Since index funds follow a consistent set of rules over time to determine what stocks and bonds to hold -- as well as which parts of the market to cover -- this provides our first major screen. The result from such a process of elimination is a list of more than 2,700 index mutual funds and passively managed exchange-traded funds with a total of nearly $10 trillion in assets from Morningstar's database.

Like mutual funds, ETFs are baskets of securities, sometimes holding thousands of different stocks and bonds. But unlike mutual funds, which are bought and sold once at day's end, ETFs can be traded ad infinitum during the day over stock exchanges like the NYSE and the Nasdaq.

This more active transactional environment can lead to vast differences between what ETF traders initially offer and how much sellers are willing to accept. The resulting "bid-ask" spread on thinly traded ETFs can be wide. The greater that divide, the "bigger the immediate loss upon buying that ETF," notes Investor's Business Daily. 

Besides monitoring these ongoing negotiations taking place in real-time between individual traders, ETF investors should be aware of another level of complexity. In order to help build volume and support liquidity for each ETF throughout the trading day, market-makers -- big institutional investors and brokers -- are given access to trade in large numbers with specific offerings.

Institutional support from such "authorized participants" is a key factor in providing enough liquidity to keep market prices in-line with an ETF's net asset value. "A fund's NAV is much like an individual stock's market capitalization, which is a measure of a stock's overall value in the marketplace," says Adam McCullough, an analyst at Morningstar. 

Market caps are determined by multiplying share prices by the number of shares outstanding. Likewise, the NAV is a calculation that divides a fund's total net assets by its number of shares outstanding. In a mutual fund, NAVs are calculated at the end of each trading session. With ETFs, NAVs are calculated throughout the trading day. 

Although any discrepancy in pricing is usually very temporary and slight in value, Morningstar's tracking of ETFs over time shows it's hardly an isolated event. In fact, a recent check of Morningstar's database found that more than a third of U.S.-listed ETFs were trading at a premium to their NAVs. (By premium, we're referring to the market price per share being greater than the NAV.)

Buying an ETF at premium pricing isn't ideal. As Morningstar puts it: "Shares in regular open-end mutual funds are bought and sold at NAV, but shares in ETFs (with the exception of creation units) are bought and sold at the market price, which can differ from NAV."

Even though IFA's portfolio management team only places the most liquid and widely used ETFs on its radar, they still find a need to watch these trading vehicles like a hawk.

Whether we're reviewing ETFs or mutual funds, IFA's Performance Monitoring Report (PMR) scores each by objectively assigning points for different types of criteria. Generally, it gives more weight to portfolios with lower turnover rates and less management "style drift." Both are important factors in evaluating fund expenses, but aren't on the radar of a lot of investors since these can be seen as implicit rather than explicit costs of ownership. 

At the same time, our PMRs tend to de-emphasize raw return data in scoring funds. "IFA’s decision to assign a lower weight to past performance is based on the requirement of a large sample size (i.e., number of years) to determine the presence of skill with statistical significance," Hebner has written in the past about IFA's PMR methodology. 

Such an evaluation process leans heavily on Sharpe ratios, which measure returns against a relatively "risk-free" investment like a one-month U.S. Treasury bill. IFA's systematic review also makes sure to compare a fund's gains to standard deviation, a statistical metric that can be used to quantify portfolio volatility against a market index. 

PMR scores are heavily weighted to internal fund holding characteristics such as market-cap sizes and "book" valuations. In particular, we've found price-to-book ratios to be effective in analyzing a fund's ability to capture key drivers of expected long-term returns. Also, IFA’s PMR places a high degree of emphasis on diversification, weighting inputs such as number of holdings and how many of these securities make up a fund's top-10 in terms of total assets. 

All of this leads us to employ passively managed mutual funds in IFA Index Portfolios.