Why You Need Mutual Funds in Your Portfolio, Even if You Own ETFs

Everyone loves ETFs: Business magazines, news channels, analysts and finance websites—no one can stop talking about them. In the last two years, they have grown to $2 trillion of assets under management (though still short of $16 trillion AUM for mutual funds). ETFs have so many good things about them: The tax benefits, the convenience of buying & selling similar shares, the low fees and the diversification are all promising and attractive features. It is a common misconception that because of these advantages ETFs are a replacement for Mutual Funds; however, this couldn’t be further from the truth. Both Mutual Funds and ETFs offer impressive diversification and convenience, but their advantages don’t cancel each other out. And, in fact, you should consider investing in both—read on further to understand why.

At the Most Basic Level – What do ETFs Really Give You?

The one-word answer to that question is indexing. A true investor never decides to invest in something only because of fees and tax considerations. The central objective is to fulfill an investment objective, and if that can be achieved by paying lower fees and taxes, then that’s the cherry-on-top. The main intention in buying an ETF is investing money in a specific index. Say you are bullish on oil for the next 6 months, and you buy a long oil ETF. And if you are short on copper, you buy a short copper or a metal ETF. If you are feeling adventurous or confident, maybe you get yourself a 2X, or a 3X, short metal ETF. Sure, the convenience is awesome—you don’t even need a short margin account to get a short ETF (read: Buying a Leveraged ETF vs. Buying on Margin). But tell me this: If you were really confident about an investment idea and you had to jump through a few hoops to execute it, wouldn’t you still do it? Most people would. On the other hand, if you had the convenience of fulfilling some sub-standard investment goals, would you do it? Consider the convenience store close to where you live—how many times do you go in there?

Why Mutual Funds Suit Most Investor’s Lifestyles

Most retail/individual investors, when left to their own devices, will probably make a mess of their investments. I have gone through that, so I know from experience. A typical greed buy and fear sell can happen to the best of us. Now, ETFs are much better than picking stocks because they reduce the risk, but they still don’t really match up to the active portfolio management a professional Fund Manager would do.

Let’s elaborate more on why that is important:

• Investments are about ideas
  Getting to know what PE ratio is by reading online, or even studying it formally, is like learning a language. Yes, you learn the alphabet and words but that doesn’t mean you can write a good story or be an engaging speaker. A lot of individual investors have a job and a family to take care of. They usually don’t have a lot of time to research, come up with theories, experiment or learn from their failures by building complexities into their theories. They don’t have the time and opportunity to meet and share ideas with other investment professionals. All of this is the hour-to-hour life of a dedicated investment professional. A lot of people think reading news and listening to analysts will give them the ideas they need to invest. While constantly dabbling in current events does give you a good background, making investment decisions from that can be disastrous. If it is in the news, you are probably already late to the party.

• Execution of ideas is an art (and science)
  After you decide what to do, building a portfolio across all the asset classes, sectors and security types is not easy. It is not by accident that trade execution is a separate department in most financial institutions. If you don’t have access to automated/ programmable trading tools, or the knowledge of how the markets function for each security type, you will probably not be very effective in your execution—you will not get the best price, miss the right opportunities, make mistakes and not counter your risks properly. On top of all of this are the emotional factors that come into play. Most personalities are not really suited to be a trader. They can be strategic thinkers and advisors, but it takes a different kind of emotional strength to be both alert and ruthlessly patient at the same time. You are not building a winning portfolio in a day or even weeks. It may take months or several business cycles before you get the things you want at the right price and time.

Are ETFs Better Than Mutual Funds in Certain Scenarios?

The short answer is YES, but only in specific scenarios. The DIY approach to actively managing your own portfolio may not be feasible (for instance, due to time constraints)—but that doesn’t mean it is automatically better to pay someone else to do it, even if they are professionals. If you are investing in a fund that likes to invest mostly in blue chip stocks and uses broad market indices heavily, you are not too far away from what a few ETFs could achieve. In other words, if you are not going to take many risks and have low return expectations, you could achieve good results via ETFs. If, however, you want to invest in high-risk instruments (say small cap stocks) or invest in a volatile market, you are better off paying a professional to do it. The need for professional help is felt the most when the markets are choppy and times are bad. You will thank your stars you were not in the driver’s seat if things go south all of a sudden.

The Bottom Line

ETFs and Mutual Funds are definitely siblings and they are similar in some ways. Like a good parent/investor, one needs to be impartial towards them. They definitely don’t cancel out each other’s needs. I don’t believe anyone can be an expert in everything; instead, you might have the opportunity or willingness to learn about a few things or deep knowledge of a certain sector. You can try and take the ETF route (or stocks/derivatives) and put your investment ideas to test for that sector. For the rest of the investment objectives, and especially because you shouldn’t limit yourself to one sector, mutual funds are still a promising way to put your money to work. I highly recommend mixing both ETFs and mutual funds as tools to achieve what you want your portfolio to do.

Note: ETF investing might appear to be simple but, behind the scenes, there might be complex derivatives at work (for example read: How to Use Inverse ETFs to Hedge Your Portfolio). This is especially true for short and leveraged ETFs where you might be exposed to the risk, even if it doesn’t feel like you did much.