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Mutual Funds vs. ETFs: and the loser is … you and me, I’m afraid

January 9, 2014 by Editor, InvestingForMe

In the investment industry the only measure of success that really counts is money – specifically how much money you can get your clients to hand over for you to invest. It doesn’t matter if you’re an investment advisor, professional money manager, investment firm, mutual fund, or exchange-traded fund (ETF). All that matters is how much money you get to work with – and charge fees on. And this money is called your assets under management (AUM).

 

All that other stuff (like investment performance, customer service, tools and resources, etc.) falls far behind when it comes to being a winner in the investment industry. But your AUM dictates how much revenue you generate, how much money you personally earn, and how your peers and firm view you. The bottom line in the industry: Get lots of client money and you’re a winner.

So when it comes to AUM, the industry’s two big guns are mutual funds and ETFs.

Mutual funds: still the biggest player

Not only do mutual funds continue to attract the majority of Canadian investors’ hard-earned savings, they’re also one of the most profitable investment products ever created by the investment industry. How profitable? We’re talking over $20 billion annually from Canadian investors in the form of investment management fees and other expenses.

Each year mutual fund companies charge investors management fees, and these companies in turn use a portion of these fees to pay for marketing materials and campaigns and generous incentives to investment advisors who sell the mutual funds to their clients.

The generous pay-outs that mutual funds make to advisors has provided the fuel for the growth in one of the largest, if not the largest sales force in Canada. The number of advisors that promote and sell mutual funds is in the hundreds of thousands! And it's because of this well organized, well-paid sales force that mutual funds continue to be the winner when it comes to the industry’s AUM.

ETFs: The new kid on the block

For the first time ever, a new investment option – ETFs – appears to have what it takes to threaten mutual funds’ dominance.

ETFs have dominated investment media news for the past 4 or 5 years (i.e. personal financial blogs, investment articles, and mainstream financial news) as being superior to mutual funds. Everyone talks about how ETFs have lower investment costs, better performance and are a better investment choice for our hard-earned savings. Why?

ETFs have been touted as the ultimate investment vehicle. They’re simple, cheap and most track established stock market indices (like the Toronto stock index, Dow Jones and S&P500 indices). So, that leads to an obvious next question. If, as history tells us, mutual fund managers can’t beat the index, why don’t we just invest in the index itself, just like ETFs do? … Hmmm, we’ll try to answer that in a minute …

Anyhow, back to more interesting ETF facts … In Canada, the growth in the ETF market has been dramatic on a percentage basis – but not so much so when you look at AUM. From a single ETF in 1990, the ETF market expanded to 17 ETFs and $6.0 billion in AUM in 2001; to 28 ETFs and $15.3 billion in AUM in 2006; to 172 ETFs and $45.5 billion in market capitalization in 2010, and to 289 with $61.8 billion (up from $54.38 billion a year ago) in AUM by October 2013. Again, on a percentage basis this growth is nothing but staggering!

To help drive it home, here’s a quick visual of what that explosion in popularity looks like in a graph:

The media loves ETFs: too bad investors don’t feel the same

While bloggers and financial writers seem to be having a lengthy love affair with ETFs, the stats show that investors for some crazy reason just aren’t feeling the attraction.

After years and years of marketing, financial commentaries and ETF investing success, Canadian investors still prefer their mutual funds. But why, you’d have to ask yourself? Is it that Canadian investors just don’t care about the higher expenses and the lagging investment performance mutual funds deliver?

On the contrary, Canadian investors have demonstrated their absolute loyalty to mutual funds with the only metric that matters – their money. For instance, in the past 12 months, Canadians have increased the AUM at ETFs by a paltry $7.4 billion, while handing mutual funds almost 20 times that amount.

That’s right!  While ETFs gained $7.4 billion, mutual fund AUM increased by $154 billion to a total of $971 billion in AUM.

With a total AUM of $61.8 billion, ETFs have only attracted less than 6% of Canadians’ savings - not so impressive on a percentage basis, right!

How ETFs work better than mutual funds

Contrary to what the investors’ numbers show, ETFs seem to tick all of the boxes when it comes to an ideal investment, while mutual funds, on the other hand, continue to tick many of the boxes that make them a poor option. For example, ETFs are

  • so much simpler than mutual funds. ETFs that track an investment index are easier to understand, monitor, and use within an investment portfolio.
  • so much cheaper than mutual funds. ETFs cost between 0.09% and 0.70% each year to own compared to 1.50% to 3.50% for mutual funds. (And we all know that every dollar you don’t pay out in management fees is an extra dollar in your pocket!)
  • consistently outperforming mutual funds. History has demonstrated that the vast majority of mutual funds consistently underperform established investment indices, whereas indexed ETFs track them quite well.

So where did the industry go wrong trying to sell us ETFs?

Good question! It just doesn’t make sense! If ETFs are just so plainly the better investment, the only thing to conclude is that the investment pros are rewarded for recommending mutual funds and are not obviously rewarded for talking up ETFs. So ETFs never really went wrong anywhere. They’re doing what they’re supposed to do, attract the most AUM possible. So, it really comes down to us. As investors, we have to become better-informed consumers.

But unfortunately in Canada the overwhelming majority of people rely upon investment advisors and their financial institutions for investment advice, and when it comes to revenue and profit, mutual funds win hands down. Mutual funds are just too profitable for those investment pros to stop selling them in favour of ETFs – regardless that ETFs might be the better investment for savings.

So, before ETFs can start to attract more of Canadians hard-earned savings, one of two things needs to change in the investment industry:

  • ETFs must start charging investors substantially more and start to pay investment professionals to recommend them to clients, or
  • The average Canadian investor must begin to take a greater interest in their investments and become more demanding in how their savings are invested. (i.e. learn that ETFs are the better investment vehicle for their buck).

Unfortunately, I doubt either of these things is going to change anytime soon and I fear mutual funds will continue to suck up the majority of Canadians’ savings. And ETFs, on the other hand, despite their popularity with the media, will sadly remain only a bit player when it comes to investing.

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