Dueling Fools: Mutual Funds

Though the acronym "ETF" technically stands for "exchange-traded fund," a better description might be "easy to trade frequently."

Built like funds, but as tradable as stocks, ETFs have become the domain of the buy-to-flip bunch. Take SPDRs (AMEX: SPY  ) ; like the Vanguard 500 (VFINX) index fund, it mirrors the S&P 500. But rampant buying and selling has led SPDRs to -- wait for it -- 3,600% annual turnover. In practical terms, that means the average SPDRs investor holds shares for about one day.

Cheap is as cheap does
No wonder Vanguard founder and fund guru Jack Bogle has come out strongly against ETFs. In his newly published book, The Little Book of Common Sense Investing, Bogle argues, "I can't help likening the ETF to the renowned Purdey shotgun, supposedly the world's best. It's great for big-game hunting. But it's also excellent for suicide."

Exactly. Those who like to trade are more likely to buy tradable funds. But even if you're not a trader, championship mutual funds -- especially when held in a tax-advantaged account -- are often cheaper to own.

Do the math with me. The investor who builds a $10,000 position in the Vanguard 500 in thirds over the course of a year is likely to pay just 0.18% of assets -- or $18 -- for the privilege.

A similar position obtained in SPDRs would cost at least the price of three trades -- let's say $30, for argument's sake -- plus an 0.08% expense ratio, or $8. That's $38 vs. $18. Assuming that each position remains stable, it could take two or more years for the ETF's edge in annual fees to wipe out the deficit created by initial trading costs.

Don't be a sector sucker
That won't always be true, of course. If you're bent on buying a sector fund, you're likely to do better with an ETF. Consider the PowerShares WilderHill Clean Energy Index (AMEX: PBW  ) . Its 0.70% annual expense ratio is well below the wealth-destroying 1.98% a year you'd have to pay for the Guinness Atkinson Alternative Energy (GAAEX) fund. And you'd still get exposure to both Fuel Systems Solutions (Nasdaq: FSYS  ) and Echelon (Nasdaq: ELON  ) , among others.

Still, this isn't much of an argument. Sector-specific investments of any sort -- whether fund or ETF -- are less likely to outperform the broader market, given how easily they can fall out of favor. Think of what's happened to the WilderHill Index since oil prices began to normalize, for example.

Profiting from the champions' choices
What really makes funds the better choice in this debate? Expertise. ETFs are quantitative instruments that rise and fall according to the benchmarks they serve. The top managed mutual funds, on the other hand, can deliver years of market-crushing performance on the cheap.

Think of the investing legends who've made their names managing superior funds: Peter Lynch, Marty Whitman, Bill Miller, and Wally Weitz, just to name a few. Investing with any of these top performers over the course of decades would have made you rich.

Today's top managers are no different. Motley Fool Champion Funds advisor Shannon Zimmerman has constructed a portfolio of aggressive growth funds that charge just 0.66% on average. These peerless picks have spanked the S&P 500 by more than five percentage points since inception. (Click here for a free peek at which funds made Shannon's list.)

The Foolish bottom line
Look, I'm not here to bash ETFs. Held for years, they can make wonderful investment vehicles. But as Bogle points out, that's rarely what occurs. More often, they become like stocks, but with the added blight of an annual bar tab that's as bad for the liver as it is for your returns.

Championship funds, on the other hand, can be cheap to acquire and own. And if managed well, they can deliver decades of market-beating returns while allowing you to sleep soundly at night. That's as good a deal as any investing offers -- and no ETF can match it.

You're not done with the Duel yet! Go back and read the other entries, then vote for the winner.

Fool contributor Tim Beyers writes weekly about personal finance and investing. Have a Foolish money tip? Tell him. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. All of Tim's portfolio holdings can be found at his Fool profile. His thoughts on Foolishness and investing may be found in his blog. The Motley Fool's disclosure policy puts the "oo" in "moola."


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 08, 2009, at 6:38 PM, desertjedi wrote:

    I'm not sure why you so rarely see comments to Fool articles but I'll give it a go. This is purely a layman's perspective.

    There are many problems with actively-managed non-index mutual fund investing:

    1) Far too few actively-managed funds actually beat the market indices.

    2) The odds that average-Joe investor finds himself/herself investing in a market-beater is very small.

    3) The odds that "hot" funds stay hot are very low. Often, fund manager's abilities wax and wane or their stock-picking style is conducive to certain environments.

    and there are problems outside of managers' stock-picking abilities.

    4) Fund selection in 401ks is usually quite limited and having access to a "market-beater" is probably quite rare.

    5) Mutual funds end up to be the investments of "couch potato investors". We were all jazzed when we started investing in funds but can any of us name all the funds we're currently invested in right now? "Eh, um, hold on - let me go check my statements. Honey, are the statements in the filing cabinet?" In my opinion, this situation is epidemic.

    I used to actively try and find funds with managers that I thought could beat the market but finally gave up - it was just too much of a shell game. Managers that can do that year after year in the time horizons we need to consider can probably be counted on the fingers of two hands. I guess my comment is a de facto endorsement of index investing - especially for those who are not "active" investors.

    I recently opened a brokerage account and became much more of an active investor. But it's more than just trading more actively, it forces you to become much more of an aware and savvy investor. In my opinion, it's the only way to avoid "couch-potato" investing. And in my search for diversification, I will absolutely be looking into ETFs.

    At some point, hopefully soon, I will address the myriad mutual funds I have scattered to the wind. I can guarantee that I won't be keeping them in the funds they currently reside nor will I be subscribing to a newsletter that tells me the 5 or 6 "great" funds where I need to put my money - I've already been down that road.

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