Exploring the Key Differences Between Mutual Funds and ETFs

Written By: Matt Jaskolka

Every week when I get the opportunity to speak with people who are interested in learning more about Carlson Financial, I am reminded that most people who are retired or soon-to-be retired have investment accounts that lean heavily towards mutual funds. In many cases, that is all that is available to select from. Today, I want to shine a spotlight on why our firm chooses not to use them as a part of our investment strategy and what we prefer instead: Exchange-Traded Funds, better known as ETFs.

Mutual funds represent a basket of securities – usually stocks, bonds, or a combination of both – that you can buy from an investment company or through a workplace retirement plan like a 401(k) or 403(b). Typically, you are allowed to buy or sell once a day. On the other hand, ETFs are traded throughout the day on an exchange, like the stocks they own, potentially giving you more flexibility.

A very important distinction between the two is that mutual funds are actively managed while ETFs are passively managed. Active management simply means the fund is overseen by a portfolio manager who takes an “active” approach of trying to pick winning stocks that will outperform the rest of the stock market. While this sounds appealing, research from Morningstar suggests that U.S. Large-Cap growth managers over a 3-year, 5-year, 10-year, 15-year, and 20-year time horizon meet their benchmarks 22.3%, 15.8%, 6.3%, 2.4%, 2.3%, respectively. Let’s say that again. Over a 10-year timeframe, active managers were able to meet their benchmarks only 6.3% of the time. Over a 20-Year timeframe, the results are even more grim, coming in at 2.3%.1

So why do mutual funds routinely fail to meet their benchmarks? Because the fund managers are under extraordinary pressure to outperform by their investors and face enormous competition if they don’t. This causes the portfolio manager to constantly think he or she needs to make changes. Run a growth fund and missed the Artificial Intelligence rally to start 2023? Good luck catching up to those who were positioned prior to this year.

The fees mutual funds charge to own them play an equally important part in their underperformance. A research report from the Chicago Booth Review states: “From an investor’s perspective, it matters little whether managers are skilled or not, because fees eat up much of whatever skill and market-beating ability exists. Before costs and fees, active managers on average beat their benchmarks by 5 bp [basis points, or 0.05%]. After costs and fees, they underperform the benchmarks by 5 bp. Therefore, the evidence continues to favor passive investing.”2 To further underpin the idea that passive management is usually better for investor returns than active management is the famous wager between Warren Buffett and Ted Seides, co-manager of Protégé Partners, a hedge fund based out of New York. Starting in 2007 and ending in 2017, Warren publicly wagered $500,000 and invited anyone to outperform him over this 10-year stretch. Warren’s investment of choice? A single S&P 500 index fund. If you want to read the full story you can find it here.3 With all the tools and resources available, the hedge fund giants of Wall Street could not keep up with a simple and unsophisticated S&P 500 index fund. Ultimately, Mr. Seides capitulated before the wager officially ended. This leaves little room for the Mom & Pop investor to think they can do better.

My intention is not to say all mutual funds are bad. In fact, what Peter Lynch did with the Fidelity Magellan Fund from 1977 to 1990 remains one of the most incredible investment performances on Wall Street. Under his management, the fund grew from roughly $20 million to $14 billion! Lynch returned 29% per year for 13 years, outperforming the S&P 500 for all but two years, for a total return of over 2,700%.4 Had you invested $100,000 when Lynch took over the fund, the end result would be about $2,700,000.  How did Lynch do this? After reading his book Beating the Street, my takeaway is “buy what you know.” An example of this would be him going to the mall and observing which stores would be busier than others. That was part of his “edge” and it worked. If you want to learn more about what made Lynch successful, I’ve included a C-SPAN YouTube video from 1994 where he addresses The National Press Club here.5

In conclusion, the individual investor is better steered towards the use of Exchange-Traded Funds rather than their active counterpart as a part of their investment strategy. They provide instant diversification with lower expense ratios and normally better performance. As a fiduciary, I use ETFs for my clients and will continue to do so.

1 Actively Managed Funds Continue to Underperform | Morningstar

2 Why Active Managers Have Trouble Keeping Up with the Pack | Chicago Booth Review

3 Warren Buffett won $2.2 million on a bet and gave it to Girls Inc. (cnbc.com)

4 Interview With Peter Lynch | Betting On The Market | FRONTLINE | PBS [1] Peter Lynch 1994 Lecture – YouTube

Say What?

Some analysts are saying “funflation” is in full force in 2023. Despite the actors and writers strikes in Hollywood, the entertainment industry is having a boom. Taylor Swift and Beyoncé tours as well as the box office success of “Barbenheimer” added $8.5 billion to US growth in the third quarter

This week in history

1950 – Charlie Brown, Linus, Lucy, and Snoopy … the whole Peanuts gang first appeared in newspapers this week in 1950.

1964 – The first Buffalo Wings are made at the Anchor Bar in Buffalo, New York.

2008 (Sept 29) – After Congress failed to pass a $700 billion bank bailout plan, the Dow Jones Industrial Average fell over 800 points, which was, at the time, the largest single-day point loss in history. (More than a decade later, in March of 2020 as the covid pandemic started to shut down the economy, the Dow lost 2,997 points in one day.)

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