Some Good Reasons to Dump Your Mutual Funds

For starters, exchange-traded funds offer lower fees, more disclosure and tax advantages.
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A couple of years ago I predicted the demise of mutual funds. I thought savvy investors would recognize the pitfalls in traditional funds and move to individual stocks and hybrid funds.

Then the market plummeted. Individual stocks became treacherous, and many experts argued that mutual funds proved their mettle during the market doldrums.

Fine. But financial planners think differently. They are moving rapidly away from mutual funds and into the exchange-traded funds on the

Amex

, where there are now close to 100 choices, ranging from broad market indices to an index of Real Estate Investment Trusts (REITs) to a

Goldman Sachs

natural resources index. There are a half-dozen different value and growth indexes, and the only health-care index fund available anywhere, so far as I know.

The exchange-traded funds are all index funds. Each one follows an index such as the

Standard & Poor's 500 SPDR Trust

(SPY) - Get Report

or the

Dow Jones 30 Industrials Diamonds Trust

(DIA) - Get Report

or the "total stock market" as measured by the

Wilshire 5000 Vanguard Vipers

(VTI) - Get Report

. None of the funds is actively managed, although experts say active funds will be available as exchange-traded funds, perhaps next year or the year after.

Cheap, Pure and Efficient

So what's the appeal? Three things: Low expenses, tax efficiency and purity of asset class, an important characteristic for a financial planner who is trying to set up an asset allocation strategy for clients.

The difference between investors who prefer active management and those like Harold Evensky who move clients' assets to exchange-traded funds is that the active group still has faith that at least some managers can beat the market.

Where you come down on the active vs. passive argument will determine whether you like exchange-traded funds. If you like passive management, you have a choice between the low-cost

Vanguard

or

TIAA-CREF

mutual funds and the exchange-traded funds.

So let me give you a quick background on ETFs, which are hybrids: a cross between the open-end mutual funds and the closed-end funds that have traded on exchanges for decades.

Four Strikes Against Old Funds

The big disadvantages to traditional open-ended funds such as those at

Janus

,

Fidelity

and

Invesco

are these:

They cost too much. The average expense ratio of a domestic stock fund is more than 1.5%, money skimmed off your investment dollar every year. We don't know what's in the portfolio. Funds are required to post holdings only twice a year, and by the time we get them, they're outdated. Funds post prices once a day, after the market close. Funds can be a tax nightmare because the portfolio manager trades securities throughout the year, handing shareholders the capital gains. Funds can be taxable even in a year when they lose money. Last year mutual funds distributed $325 billion in gains, a record, even though most lost money. According to one study, taxes shaved about 3 percentage points off the five-year returns of most fund categories. For instance, mid-cap growth funds returned an average of 9.7% for the past five years, but only 6.3% after taxes.

Exchange-traded funds offer a pot of securities, just like open-end funds. But ETFs are much cheaper. The Vanguard Vipers cost 15 basis points a year. Many ETFs carry expenses in the range of 20 to 30 basis points, with the special sector indexes in the 60-basis-point range and foreign funds a bit higher. None costs as much as 1%.

And investors know exactly what is in each portfolio. You can go to the iShares Web site or the Amex Web site and see a list of stocks in each portfolio. The shares trade throughout the day and can be shorted or bought on margin.

Taxes might be the clincher. Index funds trade less and are more tax-efficient than active funds. And ETFs have a clever device to reduce taxes further.

Shares are redeemed and created only "in kind," which means big institutions can create new shares by bringing in the actual stocks in the index or redeem shares by taking back stock. ETFs were designed with this safety valve to keep the price honest. One of the problems with the old closed-end funds was that the price responded to supply and demand; sometimes a fund traded on the exchange sold for far more or less than the underlying assets were worth. This arbitrage feature of ETFs keeps the share price at actual value.

The Capital Gains Game

Some of our community regulars have pointed out that shares of an ETF such as the Nasdaq 100 Trust trade off the actual close of the index at the end of the day. I asked Lee Kranefuss, head of individual investor services at Barclays Global Investors, sponsor of iShares, about that. He said that because the shares trade until 4:15, they reflect changes in prices of the underlying stocks between market close of the index and close of trading on the ETF.

This "in-kind" creation and redemption has another advantage. When a typical mutual fund sells shares, it sells those with the highest cost-basis first. Suppose a fund has shares of

General Electric

(GE) - Get Report

that it bought at $10 and shares it bought at $55. If the manager sells GE at $60, he will sell the shares that cost $55 to reduce capital gains tax. But what he is really doing is embedding the gains of those $10 shares in the fund because they must be paid by shareholders at some future date. So when you buy a mutual fund, you're set up to pay somebody else's gains.

Here's what an ETF does: When an institution redeems shares and takes back the stock, the fund gives the institution the low-basis stock, or the GE that it paid $10 for, keeping the higher-basis stock in the fund and maximizing tax efficiency.

These are some of the reasons Evensky says he's moving to ETFs. Like many investors, Evensky believes that equity risk premiums will decline. That makes the impact of expenses and taxes bigger "so the hurdle that managers have to overcome is so much higher," he says.

Evensky says he has also been giving some thought to his traditional approach to investing, which is to allocate money on the basis of market capitalization, distributing client assets to large-cap, medium-cap and small-cap stocks.

Though the approach is intellectually sound, he says, it is flawed for investors who must pay taxes, because the small-cap managers sell stocks that get too big to the mid-cap managers, and then the mid-cap managers sell to the large-cap managers. The same stock moves up the capitalization ladder, and the investor pays tax on it every time it is sold.

So I've made my case for exchange-traded funds. But there are so many of them. How to choose? I'll write about that next week for those who prefer a more passive approach, and the following week for more aggressive investors.

At the time of publication, Mary Rowland owned the following equities mentioned in this column: SPDR Trust and the Nasdaq 100 Trust.