191. Mutual Funds vs ETFs

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I tried to buy the best tickets possible , kind of picky about where I sit and this , this go around , I just went on with the masses and I bought the tickets , like when it comes available to the public on ticket master . And it's crazy . Have you guys ever done that ?

It's like they put you in queue and I was like number 3000 , and it counts down and finally its like , hey , its your turn to pick your tickets . And there's all these dots everywhere where all available seats are , and the dots are disappearing .

It created so much anxiety that I think I'd rather pay five times the amount at Stubhub and carefully choose my seats right . And so I was like I don't know , left field corner all right , let's do that . And so I was looking for four tickets .

That ended up , you know , there were no tickets available for four , so I dropped it to three and then some of them were popping , but they were disappearing pretty quick . So I was like pick those , man , great deal , 75 bucks . But I've never sat in that section ever .

And so I just thought I was going to be sitting in the left field corner , like I had no idea that there was an overhang and I was the back of the underneath section , so you couldn't see the fireworks , you couldn't see the jumbotron , you couldn't see the ball if it left the bat and it didn't go to the ground .

And so me and the kids are sitting there and they're all looking to me like really , this is a best you could do , but it was a cool atmosphere . Yeah , it was a cool atmosphere , so hopefully we have a good rest of the playoffs . But anyway , we're grateful for what you got right , not what you want to have .

You know we're a firm that focuses really mostly on index funds , but I've just noticed lately in some of our meetings that we've had talks about mutual funds and ETFs and people trust the process and I understand that , but I'm a dork so I like going into the weeds sometimes right . And so it's .

I wanted to highlight the differences between mutual funds and ETFs today , because you know there are so many , you know , mid-sized financial planning firms that we end up managing assets .

Clients come to our firm and I just picture these old guys , you know , sleepy , still wearing coats and ties to work , and they have their mutual fund , their mutual fund selections that they have . They've been using them since the 1980s , you know .

And so when I think of mutual funds , wherever I see a portfolio full of mutual funds , I think of two things one , a firm that doesn't know how to get with the times and the efficiency of modern day investing .

And then the second thing I think about is oh , they must be getting paid commissions because typically , at your Edward Jones locations and your other brokers , that they're getting a trailing fee from this mutual fund which we'll dive into .

So whenever I see those , I'm typically kind of turned off by going oh , okay , we have an old school portfolio here , but there's also very specialized mutual funds that are still in existence that probably have a purpose in portfolios . We're just not using those currently in our current environment , but anyway .

So let's go back a high level here and talk about mutual funds versus ETFs . So how would we explain that to someone ?

So , going into some of these differences , I guess , first off , mutual funds come set to the trading and mutual funds are priced at the end of the day , whereas ETFs , you can actually buy and sell shares throughout the day when the market is open . So that is one big difference right off the bat between mutual funds and ETFs .

So there could be a situation in a thinly traded ETF where the net asset value , the value of the underlying securities , doesn't match the price , meaning meaning that you could be paying a premium for those basket of securities or you'd be getting them at a discount now at our big big box firms . You know your black rock , your vanguard , your state streets .

That's not really a big , a big issue .

And implicit calls really means refers to that liquidity , that bid ask spread .

But as you said and mentioned , like the big , each big ETFs they're , you know , with a lot of assets , those bid ask spreads are very tight and they trade close to that net asset of value and you're not going to have as wide of a spreads but you know that they're only traded ones can have that implicit call . So that's something to be aware of .

That's correct and it's really hard for everyday people to go and figure that out right . So , yeah , so you guys , you can't stick to like the obscure ETFs . You need to stick to the mainstream ETFs , right For those at home doing their own investing . So we talk about how they're traded . What about how they're managed ?

You know whatever index that this ETF sponsor is trying to create , whereas most mutual funds are actively managed and they're trying to outperform a certain benchmark . You know whether it's the U . S . market .

They have a leverage ETFs . Obviously , you know , 3x the market on the upside . Then there's just media funds that have all but shut down their funds and moved into ETF world , right , and they used to be . Oh , with ETF it's good .

And you know , I get frustrated because I feel like the the industry should start calling them ETPs , exchange traded products , and then you would have your , your funds that were active and then passive . You also have , you know , other things , like some of the commodity funds are actually ETNs , exchange traded notes . I mean , they don't actually own anything .

They just is a promissory note by a bank to pay you the performance of something , right ? So we don't use ETNs for that reason . You know , I think about this is this is way back . But you go back to like , when layman shut down during the financial crisis , they had three ETNs that shut down . People just lost all their money right .

So people don't , people don't really think about this risk until they are in that situation .

Even that you don't really know , like , what the risk is unless you're doing a deep dive on the analysis .

So that's correct . You have a substantial amount of money inside a brokerage account and you have mutual funds . What's gonna happen , Michaela ?

When you have an ETF that can replicate that strategy and they have the very unique creation redemption process with the AP , the authorized participant , and when that happens , they're able to shelter the , the shareholders , from from having to have that tax bill . Now , if you sell the ETF and you make a profit , you're gonna pay capital gains tax .

Right , doesn't protect you from that , but it certainly protects you from being able to or surprise tax bills at the end of the year .

And so let's say that you realize that you could save a thousand dollars a year but you've got a twenty thousand dollar capital gains will take 20 years to break even . But actually if you go and look at the taxes , how much and how much are you paying in taxes on the capital gains ?

That's typically 15% , so 15% of your capital gains bill would also be going away . So when you do that , you can apply it to the cost basis , right , or To the break even point , and so a lot of times it break even comes down to like three years after that , right .

So that's something to think about when you're looking at an old school media fund portfolio and clients don't seem to push back on that .

and over again . And so when you have clients that come in and they're like I'm going to get the best rate of return ever , I want to beat the market . But then you know you go back to reality of realizing , well , in all actuality , there's what a 4% chance they do .

a passive direction .

for a minute . So I remember walking around ETF conference in 2009 . You know , this is right after February of 2009 . So we've just gone through '08 , which is a very dismal year , say the least , and people were so shocked and it's like every panel .

You have a panel about something not even related to ETFs and somehow it all come back talking about leveraged ETFs because these are relatively new products at the time . But people lost money in an inverse S&P 500 ETF . So you think , oh my gosh , the market's going to be totally down in '08 .

After what happened at the end of '07 , I'm going to buy this leveraged ETF product and I'm going to make it 15 , 20% of my portfolio and I'm going to save the day for my clients . These are advisors walking around .

There's no clients here , it's just advisors , and I think the I'll have to go back and research that , but my memory , if serves me correctly , is around 16% . Loss is what you lost by owning a leveraged inverse leverage ETF . And what people don't understand is it resets daily , so it really depends on how many up days or down days that you have .

It has very little to do with , it has nothing to do with annual return . It's daily return , right . And so when the leverage resets daily , you could have a lot of little down days and then you have one big up day that could potentially erase all the down days and , worse , put you into the red . And so that's where people , people get kind of greedy .

The idea behind leverage ETFs when they were created so that you would buy it at the open to hedge your position , but you would liquidate it by the close . So it's supposed to be a day trading instrument only and not to be held overnight . But you have retail investors who buy these things and they don't read the prospectus and they don't understand .

If they did , they probably wouldn't understand it and they end up in a really bad position , right . And there's more . You know there's more up days and down days , typically right . Or you have bigger up days and sometimes the best up days are after the worst down days in volatile markets . So statistically it just doesn't .

that's where I think we provide that benefit to our clients .

But that's basically a computer that's saying okay , this is our selection and it's replicating that . You know , every single quarter it's resetting itself .

But you know they do have that active component and they might have like a systematic process where there there's a screen , you know , looking at the top cash flow yielding , our free cash flow yielding companies in the Russell 1000 , but there's maybe a subjective component saying , hey , this isn't fit our mandate and we might make a few changes based on that .

So if you're buying if we were buying 50,000 shares or something there could be a good chance . On the other end , there's not 50,000 shares that won't be purchased , or if they do , it's had at a higher price . It starts climbing this price ladder right .

Well , imagine that in a 401k plan , like what's the best execution strategy , we have a fiduciary obligation to put forth the best execution strategy as a firm , but you may not have that inside a custodian in a 401k plan , and so basically , the ETF could be purchased and who's monitoring the price of that ?

And how do participants know and how do you measure that ? I mean , so you potentially have some bad actors that could be making more margin on those trades . And really big plans . I think what we typically see in really large plans is like what CITs, cumulative investment trusts which have cost somewhere to ETFs , if not cheaper , on the big plans .

So I don't know that ETFs will show up and said 401k plans , and that's certainly a place that mutual funds still seem to serve a very good purpose inside this plans .

And going back to fees again , mutual funds will pay 121 fees , not inside a 401K plan hopefully I had seen one recently that has 12B1 fees but basically it's paying the advisor commission , a recurring commission , to own that fund .

Something else that you see and I should mention this earlier if you go down to your bank , if you go down to an Edward Jones location , you go to buy a mutual fund , a lot of times there's a 4.25% commission on the front end , so you're going to pay 4.25% to buy the Amidst fund and then they're going to have to pay another 0.8 to 1.2% per year in 12-1

fees , right , and in expenses when the ETF typically is purchased for free . so $100 in $100 goes into being invested and there's no commission being paid to anyone . If you did pay a commission , you're paying it directly to the broker to buy the ETF .

But you know , with ETFs there are for the most part no explicit calls or trading fees at the large brokerage houses and really there's really no minimum investment , so you could just buy one share at the price of the ETF .

So in a short term though , they have like this 35% success rate , which is why you see them advertised . They'll say you know , we beat the lip or average over the last five years like three to five years is kind of their sweet spot and when the active managers could potentially outperform .

What you have to understand is we talk about this almost , I think , about every episode . We bring up the spy report , but people don't understand this and it's so frustrating that they're not grasping it .

But basically , you have the S&P 500 or the S&P tracks , indexes and active managers and says hey , based on how you invest your money , here's an appropriate benchmark . Do you beat that over the long term ? The answer is no .

You know large cap managers have a 2% chance over a 20-year period , about a 6% chance over 10 years , and then it increases from there in the shorter time period . Actually , one year is really bad . So when you're building out , you know these .

When you're looking at your investment portfolio and you see nothing but mutual funds and active managers , high fees , inefficient , investing right and you're making someone else very wealthy . Am I wrong , Andrew ? You come from a world that still has some mutual funds . I believe right . I think your old firm have some of these funds in the portfolios .

But really to me mutual funds make the most sense in certain asset classes and that's like fixed income or maybe even international equities . I'd say international equities maybe not so much recently , but you know these markets are more fragmented , they're not as efficient as the US market , so you do see better outperformance in these markets .

It's more about the high commission , the high fee that are not properly or you know that don't have a good asset allocation .

I think they started in the 1990s officially and even though they are , you know , on the market that long , it's not something that's the norm , I guess , for the industry . Still it's getting to that point . But a lot of people have heard about mutual funds . It's historically what their parents invested in , it's what their grandparents invested in .

They've been around since the 1920s . Like that's the safe option , it seems like , for people , even if they're paying that premium . So it's kind of explaining the difference of hey , the market is shifting and this actually is a better option for you in the long run , and that was a phenomenal option for them because it was the option they had provided .

But now there's a better one and it's just like the first draft isn't as good as the second draft and I think this is almost the second draft of a mutual fund kind of life . Yeah .

Spiva was created in 1991 , I believe , for the purpose of being able to hold assets in the S&P 500 while they're trying to choose which stock to buy after , you know , after a while , so they wouldn't miss out on market performance . And then that carried on into the early 2000s when we started adding more .

The ice years products came out , sort of adding more diversified mutual funds .

And then now I would argue that mutual funds versus ETFs is going to be an old conversation and a couple of years from now we're going to be talking about direct indexing .

And then we kind of go back full circle where we're going to have 116 securities inside of a portfolio individually selected by software that probably somewhat the same software that built the ETF , right , except you . You're just kind of building your own ETF and for us this is going to be as important as some other firms that have agendas in their investing .

But think about being able to buy the S&P 500 and you're going to replicate that . And then the tax , the whole new level of tax efficiency you have in direct indexing , so that's probably the future .

As I've said many times , we're an indexing firm and ETFs are the vehicle for that right now , but it may not be that way in a few years and you don't want to be first . You don't want to be first in that environment . We need others to go ahead that can fail and perfect the process , but that is something that we're certainly watching .

And then you know , as you mentioned , casey , the they call it tax alpha , but the additional you know tax savings you can get from , you know , these vehicles is phenomenal .

You know you're paying a more expensive fee to hold , for the portfolio , to hold that cash , and a lot of managers do this because they're just holding like a little cash buffer in case there is a you know a flood on the fund . There's a lot of redemption requests coming in , so sometimes people refer to as a cash track on that return .

So again , not every you know mutual fund is like this , but there are a lot of them that you know where they might have a lower performance versus an ETF that tracks the same , similar benchmark .

TD Ameritrade doesn't exist anymore because of it . And then on the ETF side , you know there's a price war between State Street , Blackrock and Vanguard on the S&P 500 . I remember when it was like 0 . 1% and then that was cheap and now it's like 0.03 . And so if they just drop it by one basis point , then they get more market share .

So it's about claiming who has the most in assets , I guess now on the flip side , it's kind of like hey , this is our free offering . It's kind of like the gimmick when you walk into the store you know , buy one , get one free right , but in the meantime they have all this ESG propaganda that you know . Don't even get me started .

We have a whole podcast on me ranting on on ESG , but . But basically is what I'm saying is it's not . I'm not weighing in on the ESG political statement . There is staying away from that . What I'm talking about is the S&P 500 has the highest ESG rating . Our portfolios have the highest ESG rating .

However , Blackrock , especially , has come out with ESG funds that perform worse than the S&P 500 . Right , have the same rating as the S&P 500 and charge you five times as much . They make 56 million dollars more year off of one large cap ESG fund . Yet our S&P 500 , which has nothing to do with ESG .

We probably own less than a half a percent of companies that maybe wouldn't show up in the ESG fund , right , right ? and yet we save 56 million dollars in fees . So it's , it's , I caught .

Well , I don't , I didn't , I didn't create this , but it's called greenwashing , where you , you say , oh we're , we're environmentally social and government's focused , and then the end , what you just did is what you just ? You just increased your cost by 5x and , and , and you made Larry Fink at Blackrock like even more wealthy than the areas and more powerful .

Yeah , and so I just kind of roll my eyes and like this is this is no different than the low vol funds . Back in the day , they came out with low volatility funds because , you know , after the financial crisis , things are so volatile and everyone moves and like herd mentality , so they all hurried to buy low vol . So many people what bought low vol ?

It became more volatile than the S&P 500 itself . Right , and so you have to be so careful as an asset manager that you're not following the marketing guidelines of whatever is out there . You know , right , it's like when we had the oil spill and the Gulf of Mexico .

You know , I was just waiting for , like the , because a lot of oil companies have high yield bonds . I was waiting for the high yield bond ex oil . You know , it's just marketing , is , is , is very . They want to manage your money . They want to manage your money because they get a percentage of that .

So you , you have to still steer clear of the gimmicky stuff and make sure you focus on the core .

They claim that they have this high ESG score but in the end they're , you know , mirroring what's in the S&P 500 , you know , just passive general ETF , and they're really not that different from a market cap waiting so no , it's no different than the other focused mutual funds that have exist .

In the end , you want to leave politics out of your portfolio building and you you want to leave your emotions out of your portfolio building , because of course it's kind of go hand in hand . But there's no place for that and you just have to manage based on what is worked over the long term . I call them long-term healthy asset classes , right ?

So S&P 500 , it's been pretty hard to beat . Very few of us over over a 20-year period and it's probably gonna continue to be that way . But the S&P 500 itself is no , hey , it's pretty woke , right .

I mean , yeah , it's all the things that we get frustrated about because that's what's , that's what's kind of the movement it's happening in these large companies , but we're not gonna buy a fund that advertises that on the on the wrapper and we had to pay it , you know , 5x for it . That's crazy , right . All right , you know we have a YouTube channel .

You guys ever watch the YouTube channel ? A Wiser Retirement .

That's a good one, well , I don't know , tune in , go find that go find out . Podcast , episode 165, 'Five Principles of Successful Investing' . That's a great episode to learn about the basics of building portfolios .

And then episode 96 back in the day, thats an old episode we talked about this selection of small cap ETFs , kind of like how we would go through and and weed out funds to pick , pick a fund . Let's see what else . Yep , thanks for listening to today's episode .

If you're interested in learning more about Wiser Wealth Management or want to schedule a consultation , meet with one of our financial advisors . You can do so by going to wiser investor . c om or you can click the link in the episode episode notes . All right , thanks guys , and thank you listeners . We'll see you next week .

This episode was produced and edited by Ken Hoadley . This podcast is strictly for informational purposes only and is not to be considered as investment advice or a solicitation to buy or sell any financial products , securities , digital assets or any other investment vehicles or a basis to make any financial decisions .

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