Mutual funds are obsolete, according to some advocates of exchange-traded funds, or ETFs. But conventional open- and closed-end funds are very much alive. Many investors have good reasons for preferring the old choices, especially now during the stock-market slump.
To appreciate the appeal of closed-end funds, consider
General American Investors
, which invests in blue-chip stocks. During the 10 years ending in July, General American returned 9.6% annually, about 7 percentage points better than
SPDR S&P 500
, an ETF that tracks the benchmark Standard & Poor's 500 Index.
The odds are high that General American will outdo the SPDR during the next decade. The reason lies in the structure of closed-end funds. Like ETFs, closed-ends typically invest in portfolios of stocks and bonds. Closed-end shares trade on stock exchanges. Responding to the whims of investors, the shares often sell at premiums or discounts to the value of the securities held in the portfolios of the funds. With investors gloomy about the markets lately, many closed-end funds have sunk to big discounts. General American sells at a discount of more than 10%. That means an investor can pay 90 cents to own more than a dollar's worth of assets in the fund. In contrast, SPDR and other ETFs rarely trade at discounts. You must pay about 100 cents to own a dollar's worth of SPDR.
In the past, General American has often sold at smaller discounts. A year ago, the discount was 7.2%, according to ETFConnect.com. As recently as 2001, the fund commanded a premium of 1.5%. As the shares revive from the bear-market low, a narrower discount would provide a nice boost for the fund's total return.
Like many closed-end funds, General American has another potential advantage over ETFs: leverage. The fund borrows money and uses the proceeds to buy stocks. General American has 14% leverage. Each dollar invested in the fund controls stocks worth about $1.14. The leverage magnifies gains in bull markets -- and enlarges losses in downturns.
Odds are good that stocks will recover from their lows and rise at least a little during the next decade. If that happens, leverage could give the closed-end an edge over the SPDR ETF. To be sure, leverage comes with risk. That's why cautious investors may only want to put a small amount of holdings in closed-end funds.
Compared with closed-end funds, ETFs have some significant attractions. They are cheap to hold and tax efficient. But many open-end index funds have similar virtues. Consider the two biggest funds that track the S&P 500,
Vanguard 500 Index
, a conventional open-end mutual fund, and SPDR S&P 500, the ETF.
By a variety of measures, the traditional fund is clearly superior. During the five years ending in June, Vanguard returned 7.45% annually, compared with 7.36% for SPDR, according to Morningstar. For investors in taxable accounts, the Vanguard edge is even wider. The open-end fund delivered after-tax returns of 7.13%, more than SPDR's 6.98%.
Skilled portfolio management enabled Vanguard to boost returns. Whenever futures sell at bargain prices, the fund holds some of them instead of individual stocks.
To lower tax bills, the Vanguard managers sometimes sell losing shares, booking losses that can offset gains. In future years, Vanguard is likely to be particularly tax efficient. With so many stocks dropping lately, the fund's managers have lots of losses that can be used to offset taxable capital gains.
For some investors, the SPDR ETF has an edge in costs, boasting an expense ratio of 0.08%. Retail investors who put small amounts into the Vanguard fund face an annual expense ratio of 0.15%. But Vanguard shareholders who can invest $100,000 only pay 0.07%. In any case, the open-end fund has a clear cost advantage: Investors can buy the no-load shares for free. To purchase an ETF, you must pay a brokerage commission that is equal to the cost of buying a stock. The cost advantage of an ETF could quickly evaporate for an investor who pays $9 or more to buy shares.
Make no mistake, not all open-end funds are run as efficiently as Vanguard's. In some cases, ETFs are much cheaper to hold than competing open-end funds. But investors considering an ETF need to do careful comparison shopping. Often the differences between ETFs and traditional funds will be small. In the end, the best decision may be to hold a mix of mutual funds and ETFs. Investors should aim to find the choice that best suits their needs -- and not dismiss any fund because it seems out of fashion.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.