ETF vs Mutual Funds. A heated debate. Let me share what I feel about these investment vehicles.

Hi everyone, I am starting this discussion by expressing my personal opinions about ETFs and Mutual Funds. Please feel free to agree or disagree. We are all here to learn new things and explore new perspectives.

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Essentially, both ETFs and Mutual Funds allow investors to build a diversified portfolio at a significantly lower cost because they take advantage of economies of scale. The main differentiating factor is their investing style and distribution channels.

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ETFs mostly follow a passive investing strategy, which means their sole purpose is to track a particular index. Due to its passive strategy, ETFs charge only a small management fee (usually less than 0.5%p.a.). The only way to invest in an ETF is to buy it through an exchange.

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Mutual funds on the other hand, mostly consist of an active investment strategy where fund managers pick and choose stocks that they have researched on. Because mutual funds involve active stock picking, they charge a higher management fee (usually 1-2%p.a.). They are not traded on exchanges but are marketed by various distribution channels such as banks and insurance companies.

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Historically, the majority of mutual funds across sectors and geography fail to outperform their benchmarks. Research has shown that there are 2 main reasons for this. Firstly, the high fees of Mutual Funds can drag down returns significantly. Secondly, the markets in developed countries are mostly efficient, hence there is little room for Mutual Funds to outperform the markets. This historical underperformance of Mutual Funds has led to a huge shift in investment monies towards ETFs.

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A quick youtube or google search and you should be able to find many financial gurus telling people to just buy ETFs because they are cheaper, and tend to outperform Mutual Funds. Some even discourage people from even trying to invest in Mutual Funds. They seem to preach the idea that ETFs are the way forward and that Mutual Funds are just out there to earn money from investors by charging expensive fees. The recent performance of Temasek's portfolio also came under fire after failing to outperform the S&P500.

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This is where I come in to give my 2cents. While I acknowledge that ETFs are a great way for investors to diversify at a low cost, I would be cautious against the growing trend of ETF investing. Investments in financial assets has only become available to retail investors in recent years. In the early 2000s, there is no MooMoo or IBKR for investors like you and me to just buy into any ETF or stock we wish. The only outlet for us to invest our monies is through insurance companies and banks, which are distribution channels for mutual funds. Hence the market for ETFs is generally very small.

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In my opinion, this is precisely why the markets have been so efficient historically. Because there are many fund managers out there buying and selling stocks, price discovery happens and the current market price generally reflects all available information. Now that almost half the world's funds are being invested in ETFs, I am not so convinced that the concept of an efficient market will continue to hold. With more investors adopting the "just buy ETF and hold for life" mentality, we could potentially enter a stage where instead of monies being allocated to the most profitable business, they may just flow to the largest companies within a market. This allocation of resources then becomes inefficient. When this happens, there will be so much more opportunities for research to turn into higher gains for Mutual Funds.

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The point I am trying to get across is: Mutual Funds and active managers are the ones that gives the markets its efficiency. It would be inappropriate to completely shut down Mutual Funds just because of historical underperformance.

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Lastly it is also worth noting that since the rise of ETFs, Mutual Funds have already lowered their fees compared to the past. We can also expect the introduction of RoboAdisors to put downward pressure on the fees that Mutual Funds charge.

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These are just my own opinions based on my own research. Please share with me your thoughts. Do you agree or disagree that ETFs are the only way we should invest moving forward?