ETF vs. Mutual Fund Debate Comes to a Close

BOSTON ( TheStreet) -- In the competition between mutual funds and exchange traded funds, investors are often persuaded to buy one over the other. It shouldn't be that simple for individual investors, says Doug Kreps, managing director of Fort Pitt Capital Group.

"The good and bad of Wall Street is that it will invent any product to fit any perceived need in the marketplace," Kreps says from his office in Pittsburgh. "The challenge for investors is figuring out which product they truly need."

But even with his plea for sanity in the mutual fund versus ETF debate, Kreps has his own preferences. He has seen new business come into his firm that included several portfolios containing highly specialized exchange traded funds, or ETFs. He wasted no time in swapping out of those investments.

"For these clients, owning ETFs was more of a momentum play. It was a trading strategy, not an investing strategy," Kreps says. "We've converted those clients, and they're happy now."

And so begins the latest volley in the war of words between proponents of mutual funds and ETFs, a debate that has become Wall Street's own version of the Hatfields and McCoys. In one corner are those who disdain the bloated fees of mutual funds, bemoaning the lack of transparency, the "style drift" of portfolio managers and the chronic underperformance compared with stated benchmarks. In the other corner are those who say ETFs are a risky trading vehicle, not a strategy, misused by investors who come to Wall Street as if to enter a Vegas casino.

ETFs have become a cheap and popular way to diversify or hedge positions. Despite the fever-pitch demand, ETFs still lag well behind mutual funds in terms of assets.

The combined assets of U.S. mutual funds totaled $12.1 trillion in March, according to the Investment Company Institute's official survey of the mutual fund industry, while the combined ETF assets were about $1.1 trillion. This isn't an apples-to-apples comparison, considering that ETFs have been kept out of 401(k) accounts.

The sharply opposing views over the benefits and drawbacks of ETFs and mutual funds isn't surprising. And even though he converted clients out of portfolio positions in ETFs, Kreps doesn't take a spiteful stance against a different trading approach as his own.

"I'm not out to say ETFs are a horrible thing. I honestly don't believe that," Kreps says. "But they are being misused. They're a wonderful tool if you're an institutional manager trying to hedge risk. They've made it cheap and accessible for professional money managers to hedge risk in a portfolio. But you're throwing gasoline on a fire when a retail investor can put their money in an ETF and expect great results."

Not everyone agrees. Paul Simon, chief investment officer at Tactical Allocation Group, moved to all-ETF portfolios. He offers harsh words about mutual funds.

"The integrity of what you get with an ETF is far superior than what the mutual fund is able to deliver," Simon says. "That business model -- that franchise -- which has had a stranglehold on Wall Street, is slipping away."

Simon says his firm has $1.5 billion in assets under advisement, and he strictly uses ETFs.

He came to favor ETFs after performing asset allocation studies and studying managers. Simon hit on one of the major subjects of modern portfolio theory. "What kept coming back over and over was the majority of the value being added was on the asset allocation work, not picking the best manager who could buy the best stocks and bonds," he says. "If the bulk of the returns and the risk is determined by asset allocation, then Wall Street has it backwards. You should spend most of your time on asset allocation and not on picking the best funds or stocks."

What should a retail investor understand about ETFs? Simon says ETFs offer investors their own cost basis and more liquidity than mutual funds. He also says that ETFs allow investors a specific, almost surgical, way to tilt their portfolio with precise allocations, whether it be for sectors, individual countries or commodities.

Take gold, for example. As the precious metal raced to an all-time high of $1,569.32 an ounce in April, the SPDR Gold Trust ETF climbed 9.5%, giving investors an easy way to play a rise in the hard commodity.

Most of all, ETFs allow investors far more transparency with dramatically lower costs, Simon says. "You know exactly what you own," he says. "It's not subjective, it's objective. There's more of a science to how they build an ETF."

Mutual funds typically publish outdated information, such as fund holdings, Simon says. He also criticizes style drift, which occurs when a fund's holdings don't align with its investing mandate. Style drift occurs when managers attempt to close the gap with a benchmark or get extra performance. As a result, individual investors may be exposed to risks they're unaware of.

But worst of all, Simon says, are the costs associated with mutual funds, many of which are hidden and cause confusion.

"I challenge someone to get a prospectus and sift through it and understand what the true costs are," Simon says. "You have to ask for the statement of additional information, which most people never do."

Fort Pitt Capital Group's Kreps, though, says ETFs are only a means of accessing a portion of the market.

"One of the things an active manager in a mutual fund does is follow a strategy," Kreps says. "By identifying a strategy and then hiring a manager who is going to follow that strategy, we think there is the ability to add value."

Kreps also argues that investors take on more risk with ETFs. "The idea that an investor sitting at home with a TD Ameritrade account can go online and can buy a gold ETF or silver ETF for next to nothing and they have no clue what risk they are really taking."

Michael Iachini, managing director of investment manager research at Charles Schwab Investment Advisory, offers a voice of reason in the debate between mutual funds and ETFs.

"It's mistaken to say ETFs or mutual funds are more risky than the other. It definitely depends on the fund," Iachini says. "You certainly can find ETFs that are extremely risky, like leveraged ones or very small niche ones where there is volatility. But the same is true in mutual funds, like ones with a wide-open mandate."

Iachini says it's unfair to criticize ETFs for making trading easy, as many ETF investors follow a buy-and-hold strategy for low costs and diversification. He also says it's not fair to say mutual funds can't beat benchmarks because of their costs.

"In any market environment, some active managers are beating the benchmarks," Iachini says.

So what should an investor do? ETFs are a good start for staying invested in the market with low costs, he says.

However, most investors have a tendency to seek out active management because they want to beat the market, not match its performance, Iachini said.

"If you like active management and the chance of beating the market, you'd prefer mutual funds," he says. "But for most investors, it'll be a mixture of both."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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