The ETF versus the mutual fund is like comparing apples to oranges, says one financial advisor.
Ontario advisor Kevin O'Brien claims ETFs are attractive to those simply looking to beat the index - a strategy he believes is misguided.
“Although ETFs have a place, they are being used wrong,” he says.
Because it’s not always in an investor’s best interest to beat the index, O’Brien says, referencing the rush for Nortel stock in 2000, which peaked to a high of $124.50 that July (the equivalent of $1,245 today) and plummeted to $24.60 (or $246 today) just three months later. By the time the company filed for bankruptcy in 2009, shares were worth just 39 cents.
Investors, O’Brien says, were left in a scramble, unable to sell their shares as all the ‘phoney’ wealth disappeared.
“In less than 35 days, they (Nortel) went from hero to zero. When you follow an index, you are following it down too,” he says. “There are always those darlings out there that create froth in the markets and when they fall, you want liquidity to get out.”
On mutual funds, O’Brien explains that the approximate 80 per cent of the actively-managed mutual funds run by Canada’s big banks are intentionally set not to beat the index, as investors are complacent with average returns. "The banks know that if they mirror the index the chance of them losing that client due to poor performance is non-existent," he says. "The banks corporate mandate to their fund managers is like a Goldilocks scenario. They keep their job if their fund performance is not too hot and not too cold - in other words average."
“They don’t try to outperform the market. These fund managers are counted as being 'active investment managers,' and they are not,” he says. “So, there’s a problem with the data. A closet-indexer can’t be called active.”
Finally, on the cost advantage of ETFs over mutual funds, O’Brien says it’s all about how the numbers are spun, referencing that an investor who sees a fund return at 13.75 per cent over 10 years compared to the index, won’t mind paying the 2.5 per cent MER. Whereas, with an ETF the value can be adjusted based upon the index, adding ‘false’ wealth.
“When Nortel failed, they had to take that out of the index. When that happens the index becomes a phoney measurement that is replaced with something else,” he explains. “With an ETF, that’s a permanent loss, and then you have to buy whatever new thing they put out there, and that’s not included the cost calculations comparing ETF performance over mutual funds.”
So, when is an ETF the right choice?
O’Brien says when you want temporary exposure - or short-term trading - not because you think fund managers don’t beat the index. That’s just wrong, he says.