The mutual fund, time-honored champion of small investors, is facing a fast-rising challenger in the exchange-traded fund.
They are fighting for your investment dollars. Although ETFs are much smaller, some experts predict they ultimately will win the long-term confrontation.
"In a year such as 2008, when returns are low or negative, every 50 basis points [half of a percentage point] make a difference," said Tom Anderson, head of ETF research at State Street Global Advisors in Boston. "Because ETF fees on average are dramatically lower than those of mutual funds, the difference is huge."
ETFs, which hold baskets of stocks or bonds as mutual funds do, replicate market indexes or sectors with the goal of low-cost diversification. They are traded on an exchange, so you can buy and sell during market hours, unlike a mutual fund, in which you trade shares at the end of the day. Although you must pay to trade ETFs, annual fees are generally lower than index mutual funds.
"A number of value-oriented ETFs have done astoundingly better than active mutual fund value managers this year," said Ronald DeLegge, publisher and editor of ETFguide.com in San Diego. "While, in theory, the active manager can raise cash and protect capital, that hasn't been working out because some top value managers are performing badly."
In some ways, comparing mutual funds with ETFs is apples to oranges.
There is a buyer for every ETF seller because they are traded on exchanges, so an ETF doesn't have to scramble to sell holdings to meet a rush of shareholder redemptions, as mutual funds sometimes do. No minimum initial investment is required with an ETF, and there are no penalties for redeeming shares. Dividends are paid in cash, rather than reinvested as in a mutual fund. And annual fees are lower.
An ETF strong point has been the ability to quickly add specialties, including commodities, solar energy and foreign currencies.
Many investors have no exposure to commodities, which are obtained most easily with ETFs, DeLegge said. Examples are iShares GSCI Commodity-Indexed Trust or PowerShares DB Commodity Index Tracking Fund.
"If you're looking for active money management, ETFs in their current form aren't there yet," said Scott Burns, director of ETF analysis at Morningstar Inc.
The hottest examples are "quantitative active" ETFs, which operate on a quantitative model in their selection process, much as many hedge funds do, Burns said.
Two of the oldest successful examples of quantitative active ETFs are PowerShares Dynamic Large Cap Value ETF and PowerShares Dynamic Mid Cap Growth ETF. Both keep their expenses low.
Despite recent strengthening, the U.S. dollar has popularized ETFs with international focus this year, Anderson said. Between the SPDR DB International Government Inflation-Protected Bond ETF and the SPDR Lehman International Treasury Bond ETF, more than $1 billion in new money has been invested, he said.
When considering the competition between ETFs and mutual funds, it's important to consider the might of the long-standing champ. The mutual fund has gained vast acceptance, including through 401(k) company retirement plans.
"There are over 700 ETFs, with just under $600 million in assets, compared to about 8,000 mutual funds, with $11 trillion in assets," Anderson said. "It will, therefore, be a long while yet before one can realistically talk about ETFs becoming bigger than mutual funds.
"This year, it largely hasn't mattered if you were in an ETF or a mutual fund, but rather what asset class you were invested in," Anderson said. "Money moved into commodities and bonds has done well this year, while you got hammered if you stuck with international or U.S. equities."
"One thing investors tend not to understand is the concept of style investing, because they tend to compare everything to the S&P; 500," said DeLegge, who considers it important to have a reliable benchmark to which you can compare your holdings. "Investors must understand that a small-cap value fund should be compared to a small-cap value index, not just to a small-cap index."
Andrew Leckey is a Tribune Media Services columnist. E-mail him at yourmoney@tribune.com.