Index Mutual Funds Need Warning Labels Like Cigarettes

Worldwide Invest Better Day 9/25/2012
Worldwide Invest Better Day 9/25/2012

Index mutual funds were a brilliant idea. Key word: were.

But they're no longer good enough.

They've been outdone by a cheaper, all-around superior competitor -- yet predatory practices have kept index mutual funds in business. It's time for that to end, and the solution is a warning label on such funds like those on cigarette cartons.

The new kid in town
In days of yore, investors who didn't want to pick individual stocks had basically one choice: Invest in a mutual fund, which mostly meant paying the fund managers hefty fees to underperform the market, as more than 80% of mutual funds did -- and still do.

Then, with a stellar luminous burst, in strode index funds. Suddenly investors could literally invest in the market. By simply owning an index, there was no need to pay fancy managers, so fees were dramatically cheaper. And index funds outperformed the majority of those pricey actively managed funds.

Index funds were a fantastic innovation. One thing about innovation -- it keeps on trucking. And innovation has delivered another glorious win: the index exchange-traded fund, or ETF, for short.

Why are index ETFs so great?
For individual investors like you and me, index exchange-traded funds are superior to index mutual funds in pretty much every way. It's like comparing skiing in Colorado to skiing in Pennsylvania -- in Colorado, the snow is better, mountains bigger, lift tickets cheaper, skiers friendlier (my personal opinion, anyway), and views more magnificent. The experience is simply superior on every axis.

Same for comparing index ETFs to index mutual funds. Here's why.

  • ETFs are more flexible: To invest in mutual funds, you have to go through the mutual fund company itself, sending a check or moving your money electronically. You can only buy or sell mutual fund shares once a day, at market close. ETFs, on the other hand, trade on exchanges just like stocks. To buy or sell shares, you simply click over to your online brokerage account and trade the same way you would a stock, anytime during market hours. And, if you are so inclined, you can trade options on ETFs just like on stocks. And you can short ETFs, so if you wanted to, say, hedge part of your portfolio, you could short an index ETF against your long positions. Neither options nor shorting are possible with mutual funds.

  • ETFs incur lower taxes. Mutual funds have to deal with fund flows -- investors depositing or withdrawing money from the fund -- and that turnover can provoke taxes for all shareholders, even if you don't do any trading yourself. In ETFs, when a shareholder pulls money out, the ETF technically delivers the actual stocks rather than selling them and incurring tax bills. This structure keeps ETFs taxes to a minimum.

  • ETFs are cheaper. This is the big one, because the main benefit index mutual funds initially capitalized on was their lower fees, compared to actively managed mutual funds. The reasons, again, are structural -- ETFs simply have a lower cost structure with which mutual funds cannot compete. This shows up in the numbers. For example, the average equity mutual fund fee is 1.44%, compared to just 0.53% for the same category of ETFs.

Expanding on the last point, index mutual funds are much cheaper than the average ETF, averaging 0.14% in fees last year. But this figure is misleading. First, it doesn't account for load fees, which are hefty slugs of cash that even a few index mutual funds charge when you invest or withdraw money. Also, this asset-weighted average is pulled down by a few cheap, very large funds -- the cheapest 25% of funds command 80% of index assets -- and does not reveal the long tail of smaller, expensive funds. Finally, this figure includes institutional share classes of mutual funds, which do indeed come with very low fees but are not available to individual shareholders.

Moreover, even with all the misleading details of that figure, the major index ETFs are still cheaper. The SPDR S&P 500 ETF (NYS: SPY) , the largest ETF in the world, charges just 0.09%. Vanguard's Total Bond Market ETF (NYS: BND) demands just 0.10%, and its Total Stock Market VIPERs ETF (NYS: VTI) just 0.06%. And although buying and selling ETFs requires going through a broker, many brokers offer commission-free ETF trading within a certain family of funds.

Why are mutual funds still winning?
ETFs are hardly new. The first launched in 1993, and since then more than 1,400 have launched, comprising about $1.3 trillion of investors' dollars. But that is peanuts compared to the more than $25 trillion in mutual funds. I can understand if an investor wants to hand money over to a fund manager working to outperform the market (even if very few actually do). Most ETFs are index funds, so mutual funds remain the primary venue for active management.

The new predators
But what incenses me is that even index mutual funds remain more popular than their ETF counterparts: More than $1.1 trillion of U.S. investors' money is in index mutual funds compared to $700 billion in index ETFs. And new index mutual funds are launching; 18 came out last year! These are the same exact product, except that in many cases, ETFs are cheaper. Why the heck are mutual funds still winning?

I believe the reason is that certain players in the index mutual fund industry are now, like the active managers they initially worked to replace, preying on the ignorance of individual investors. Tons of people own mutual funds -- a full 44% of American households own at least one. Most people aren't savvy investors, and many couldn't even tell you how much they are paying, much less be able to identify more attractive alternatives like ETFs. Worse, most mutual fund investors aren't even making the decision themselves; a full 80% had the decision made for them by financial professionals, who are often enticed by fat sales commissions to direct money into certain mutual funds.

How can we rectify this?
Our solution is simple: On all communications with shareholders, all index fund products -- mutual funds and ETFs alike -- should be required to prominently display their fee.

Right next to it should be the average fee for their index category.

You wouldn't fuel up your car at one gas station if the one across the street was selling it for 30% less. And you wouldn't buy a car at one dealership if you could get the identical vehicle more cheaply down the street. Why on earth do we allow index mutual funds to prey on the ignorance of individuals investing for their futures?

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Alex Papedoes not own any stock mentioned. The Motley Fool is short S&P Depository Receipts. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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