Why Mutual Funds Are Here to Stay

The way some people are talking, you might think that the multi-trillion-dollar mutual fund industry's days are numbered. But as long as investors believe they can beat the market -- and there will always be believers -- then mutual funds will have their place among investment opportunities.

Dealing with the competition
The latest issue of Money included a feature questioning whether mutual funds were on their way out. The argument goes something like this: In recent years, exchange-traded funds (ETFs) have erupted on to the financial product scene with amazing strength, cracking the $1 trillion mark and continuing to grow. Their low costs and widespread coverage of nearly every niche of the financial markets has made them especially attractive to many investors.

What has held ETF growth back, however, is the need for investors to pay transaction fees every time they buy or sell shares. Those costs have made mutual funds much more attractive to periodic investors, who tend to add relatively small amounts of new money on a monthly basis.

With recent initiatives from Charles Schwab (NYSE: SCHW  ) , Fidelity, and Vanguard to offer ETFs on a commission-free basis, Money argues, that final obstacle toward widespread use of ETFs is now gone. Therefore, mutual funds no longer serve any purpose that ETFs can't do at least as well, if not better.

There's an index for that
So far, the success of ETFs has come from two very different sources. On one hand, ETF investing hinges on the principle that passively following an index at low cost brings better results than actively managing investments at higher cost. Just as Vanguard's 500 Index Fund revolutionized low-cost investing nearly 35 years ago, so too did SPDR Trust (NYSE: SPY  ) in bringing the baseline S&P index fund to trade on exchanges.

On the other hand, the popularity of leveraged ETFs shows that while investors don't necessarily want their funds to trade actively, they themselves do want to move in and out of various markets frequently. With average volume of nearly 50 million shares, UltraShort S&P 500 ProShares (NYSE: SDS  ) has definitely cultivated a following of active traders.

The constituency that ETFs don't serve very well, however, is the group of investors who want to pay for a manager to trade actively on their behalf. And despite the historical difficulty of active funds to keep up with indexes, you'll always find at least some market-beating managers, along with hordes of wannabes who lure investors to their funds. Even great investor Peter Lynch has argued that active managers will produce better returns over the next decade than index funds and ETFs.

Active ETFs?
ETF providers are moving strongly toward actively managed offerings. Allianz's (NYSE: AZ  ) Pimco filed to enter the active ETF arena two years ago. Now, no less a player than BlackRock (NYSE: BLK  ) has filed for actively managed iShares stock ETFs. Major competitors are almost certain to follow suit. They believe that transparency and lower costs can actually help investors.

Yet major mutual fund management companies Franklin Resources (NYSE: BEN  ) and T. Rowe Price (Nasdaq: TROW  ) won't let their billions in profits over the years go away without a fight. Along with big players Fidelity and American Funds, they'll point to the fact that less frequent disclosure actually benefits their clients by making it possible to enter positions gradually over time, rather than risking frontrunners looking at daily ETF disclosures to buy shares ahead of ETFs.

In addition, fund companies can tout customer service advantages. When buying an ETF, the service you get is only as good as the broker you use to buy shares. Having the ETF wall between you and the company that manages your money threatens your ability to get direct contact on important fund-related issues that your broker may not be able to answer. Most mutual fund companies have systems in place to handle coordinated tax reporting and cost basis tracking, which can get complicated with fund shares. Moreover, the ability to reinvest dividends into more mutual fund shares is something you won't find with every broker offering ETFs.

Don't give up on funds
In the end, you and other investors will be the ultimate decision makers as to whether mutual funds continue to thrive. As useful as ETFs are, though, mutual funds are likely to continue to play an important role in portfolios for years to come.

Learn more about mutual funds in the Fool's Fund Center.

Fool contributor Dan Caplinger isn't running away from mutual funds, although ETFs have definitely been useful. He doesn't own shares of the companies mentioned. Charles Schwab is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletters today, free for 30 days. There's never been anything with more staying power than the Fool's disclosure policy.


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