This is a guest post penned by Shishir Nigam. I met Shishir a few years ago while giving some presentations at the University of Toronto. Now, he is the Founder of ActiveETFs | InFocus (http://etfshub.com), the only site on the web providing focused coverage of Actively-Managed ETFs. He is also Chief Editor at Young & Invested (http://youngandinvested.com).

The Staying Power of Mutual Funds

Mutual funds are ingrained in nearly all retirement portfolios, whether we’re talking about RRSPs in Canada or 401(k) plans in the US. They’re so ingrained that in the US, most of the operational systems used to invest client funds can only handle mutual funds because they are designed to settle 1 day after a purchase or sale, whereas other products such as ETFs and stocks settle 3 days after a purchase or sale. When operational limitations like this are the biggest challenges to new products entering these retirement portfolios, instead of the actual merits of the product, you know the incumbents will not be giving up share to ETF issuers easily.

The Numbers

When Preet gave me the opportunity to write something for the readers of WhereDoesAllMyMoneyGo.com, I decided I’ll start by presenting the most important facts people need to know about the mutual fund versus ETF debate.

Canadian mutual funds are considered to have some of highest fees in the world. This was first concluded by a study in 2007. Canadians on average had to pay an expense ratio of 2.56%, compared to 1.29% worldwide and 1.11% in the US. This is largely a product of the oligopoly that is the Canadian mutual fund space, with the 5 major banks taking up the biggest market share. Here’s what this means in $ terms. The chart below shows you what two portfolios, one using ETFs and one using mutual funds would look like over 20 years, with markets providing a 5% annual return. I’ve given the mutual funds the benefit of the doubt by using a 2.20% expense ratio, assuming they would have become slightly more competitive since 2007. And I’ve used a 0.75% expense ratio for ETFs. The difference in fees creates a final difference of more than $5,300 on a portfolio that started off with $10,000.

What’s keeping mutual funds in their place?

What I’ve presented above is not news to anyone reading this article, the benefits of ETFs have been clear and well-discussed on this blog and many others since ETFs really took off in the last few years. But despite this, the penetration of ETFs into traditional portfolios has been slow. I have a theory on why that is, and why that might be about to change.

The superiority of ETFs was confirmed in 2009 when for the first time assets managed by Index ETFs overtook those managed by index mutual funds. But take note, this progress was restricted to the passively-managed space. Passive or index mutual funds make up only about 10% of all mutual funds, with the other 85-90% being actively-managed. Which brings me to my point – despite years of debate on the inability of active management to provide any benchmark beating returns, investors have continued to pile into active funds. This I believe is due to investors just not being satisfied with index returns.

People like to put their faith in a star manager whom they believe can do well, and faith is an often underestimated quality. People want a knowledgeable market expert to at least attempt to beat the market, rather than settle for the market return. Given an offer to receive a guaranteed $25 or a 10% chance to receive $200, most people will take the chance even though the math is against making that choice, because they believe in themselves to beat the odds. And this is what we see in the active versus passive debate as well, where investors believe they can choose the market-beating manager. With most people looking to invest their money in active strategies, ETFs haven’t been an option because of their passive nature even though they are cheaper and more tax efficient etc. But that’s changing.

Actively-Managed ETFs enter the stage

Actively-Managed ETFs differ from traditional ETFs in that the money you put into these products is actually managed by a portfolio manager practicing active management, attempting to beat the market and their benchmark, just like every active mutual fund. So in essence, Active ETFs now provide those investors looking for active management (which is most of them) the option to get what they are looking for through an ETF structure.

Active ETFs debuted in the US in 2008 and in Canada in 2009. Today, there are 5 providers of Active ETFs in the US and 1 in Canada. Head here for a complete listing of current actively-managed ETFs. Most of these products are managed by stars from the active space that investors can put their “faith” in.

What all this means is that finally, both categories of investors, those looking for active managers and those just looking to follow an index, have a way to invest through ETFs and benefit from the 4 main advantages that they bring. Mutual fund issuers might have just lost their monopoly on the last carrot they had been able to dangle in front of investors all this while – the promise of active management.

Thanks Shishir – some good points to consider. I’ll add that the long-term fee impacts are magnified when using a lower cost index ETF portfolio which may have a blended portfolio MER of lower than 0.75% – which makes it all the more compelling.