Mutual Funds are better than ETFs. Here’s why.
I am sure most of you have heard that the key to a great stock portfolio is to find an ETF with a low expense ratio and good growth history. While this approach will undoubtedly work, it is not optimal.
Following the COVID-19 pandemic, virtually every fund having to do with U.S. and global stocks took a massive hit. As we learned from the 2008 stock market crash, the best course of action was to stay in the market and wait out the storm. As time progressed, we saw most ETFs and mutual funds recover at expected rates. However, some mutual funds skyrocketed. The difference? Stock selection.
By nature, exchange traded funds track an index (frequently the S&P 500) and hold an array of stocks that update on a quarterly or annual basis. The update has certain criteria, and it happens almost automatically. Some of the criteria includes having a market capitalization of at least $11.8 billion and being a U.S. company. This means that when the market drops or rises for any reason, the fund will keep the same holdings unless new companies qualify, and an update date occurs. Due to this feature, the management fees and expenses associated with ETFs are significantly lower than that of mutual funds because there is no one actively managing the fund.
On the other hand, mutual funds can contain whatever holdings the portfolio manager(s) decides, whether it be aimed at a goal of growth, dividend payment, value, or simply the size of the company. Because the holdings can change at will (as indicated by the turnover ratio), and because a team or an individual is actively managing the fund, fees tend to be higher. This alone is a turn off to many investors looking for a simple fund with low expenses, and a good track record of growth.
While my opinion on the two types of funds have fluctuated over the years, the COVID-19 pandemic really settled the score. How did it? When I noticed my mutual funds had been growing exponentially higher than my ETFs. Why? You guessed it, stock selection.
As seen in the graph above, my mutual fund took off following the low in March of 2020. This happened because the portfolio managers saw an opportunity that an ETF could not account for.
Adjusting on the Fly
After the lockdowns began, it was slowly becoming clear that Americans would be sitting idle for a while. Many companies made the decision to continue their work, but not to continue in-person work, and for good reason. This led to the rise and investment in companies like Zoom Video Communications, Inc., and Microsoft Corporation, both of which had platforms for communicating over the internet face to face.
Many mutual funds took advantage of this trend and adjusted their holdings for the new way of life for the next year. This was not unique to just video communication. Existing online in all facets of life became the new norm, and portfolio managers knew this would be the case.
In the example above, I used the S&P 500 and Morgan Stanley’s Growth Portfolio Class A. For fiscal year end 2020, the mutual fund grew a whopping 115.57% after fees and reinvestment of distributions. Conversely, the S&P 500 earned 17.88% after fees and dividend reinvestment. If you had invested $10,000 at the low point in March of 2020 in both funds, you would have almost $7,500 more profit from the mutual fund.
But how do mutual funds compare when we are not going through a pandemic? Good question. It is true that most mutual funds do not outperform ETFs like the one I am showing above. The truth is that it is pretty hard to outperform. You can see in chart below that even between the S&P 500 and MSEGX, historical returns since 2000 are not incredibly different.
If you are in the stock market for the long haul (i.e. retirement), then it makes sense to explore higher growth opportunity funds. While past results do not guarantee future outcomes, it is still nice to know that that your fund is actively managed with a goal of outperforming its benchmark. On the bad years, growth mutual funds often mirror ETFs. On the good years, they can substantially outperform them.
Conclusion
All of this is to say that no matter which fund you choose, you should still see great growth in your portfolio. But I do think it is worth looking into actively managed mutual funds, especially if you are wanting an extra set of eyes on your holdings. Keep in mind that I am not a portfolio advisor, and this is strictly my opinion.
My advice would be to invest in array of funds to ensure your portfolio is properly diversified in hopes of handling any stock market climate. Investing in ETFs as well as mutual funds are a great way to ensure you keep up with the market, but also have the possibility of exceeding it. I have both in my portfolio and suggest you do too.
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