Sunday, February 17, 2008

ETFs and Mutual Funds – The Slowdown Will Teach Us another Valuable Lesson

ETFs have become the investment tool of the 21st century for household investors. It is true, they do have many advantages ranging from lower commission, better performance, tax considerations and more.

With ETFs becoming increasingly popular more investors ask themselves why invest in mutual funds altogether?

I am a big supporter of investing in ETFs. There’s nothing more enjoyable then watching how simple financial assets outperform the big money in mutual funds constantly preaching to the household investor when and what to buy. Mutual fund managers have nearly completely failed in justifying the commissions they charge with very little abnormal returns to show for.

However, and there is always an however, sometimes the judgment and discretion of an investment manager is required. If you’re wondering when that may be the case, please consider the following behavior pattern I believe explains why ETFs outperform mutual funds and why there is a lesson to learn in the current slowdown.

First, I believe we should give grace to mutual fund managers. These are professionals using the best financial tools and data available. Why can’t they beat the market? I believe the answer lies in the market’s psychology. Markets in strong trends tend to overshoot. This phenomenon can happen in either direction – up or down. Mutual funds managers pick great stocks for their portfolios. But in a strong bull market they simply can’t foresee the psychological overshooting effect which affects some stocks and leaves other untouched.

In bull markets we’re all successful investors. Everything you invest in seems to yield unbelievable returns in a short time. I believe huge amounts of money get invested in whatever comes to hand and mind causing an overshooting effect and overpriced stocks. While the market is still bullish no one happens to notice and ETFs over-perform simply because they enjoy the full extent of the psychological effect.

It’s a whole other story when it’s a bears market. The overshooting effect works downwards and ETFs experience the full effect while mutual funds, which have picked some of the better stocks, are less affected.

I believe mutual funds will prove to be the better investment in these bearish times. We should make good use of the managers’ discretion until we’re in a strong bull market again. Then we’ll ride the psychology on the back of ETFs.


AEI said...

I still don't see that mutual funds have done any better on average than ETF's. The advantages of ETF's outweigh the hidden costs of mutual funds. I guess we have to be more specific about the investment sectors we are talking about too. The international ETF's are performing quite well in Brazil, China, India and Russia.
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theWild1 said...

I am not a fan of mutual funds no matter what market it is. It is good for those that don't have time to keep up with the market, but other then that I think the average trader can beat them.

Dorian Wales said...

I have to disagree. The average investor constantly fails in his investments (mostly due to lack of self discipline). Naturally, it depends who this average investor is but when it comes to household investors I believe mutual funds are, at least, the better "evil".