Portfolio building blocks: Mutual Funds or ETFs? Should there be a dilemma?

Ahmed Farooq, CIMA®, CFP

Ahmed Farooq, CIMA®, CFP
Vice President - ETF Business Development at Franklin Templeton Canada

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As I travel across Canada meeting advisors, I often find myself getting drawn into debates about whether Mutual Funds or ETFs are the better product. I believe both Mutual Funds and ETFs can play an important role in a diversified portfolio—it all comes down to the structural difference between the two investment vehicles. Either investment type may be better for you depending on how you run your investment practice.

Recently, I met with a portfolio manager who had been using individual securities and mutual funds for decades as the building blocks of his clients’ portfolios, and didn’t see any benefit to adding ETFs. He told me he was weary of how the industry was changing. He complained that there were too many product options, too many investment mandates, and too much to worry about. He felt that Mutual Funds were easier to use because he didn’t have to worry about bid-ask spreads, liquidity fears or worrying about executing larger-volume trades.

We had a really good conversation and his objections were all relevant. I explained to him that some of the concerns he held about ETFs were broadly-held misconceptions, and how easy it was to get swept away by the tide of misinformation. I wanted to peel back this layer of myths, by showcasing to him some of the unique benefits that ETFs actually offer. 

The benefits of live pricing

Some advisors worry about the discrepancy between the market price and the underlying NAV. However, it is important to recognize that ETFs are an open-ended mutual fund trust that trade on the stock exchange. The advantage of this is that you are able to trade on the exchange based on the current, real-time market price. So for example, if you are a discretionary portfolio manager looking for scale through bulk trading, having the ability to manage your buy and sell points throughout the day makes ETFs an attractive choice for your business. However, if you are more comfortable executing trades at NAV, then a mutual fund mandate may work better for your business.

The benefit of market makers

Some advisors also avoid ETFs because they fear that ETFs will become illiquid, but one thing they tend to forget is that the ETFs actually have two levels of liquidity. The primary market—where the stocks inside the ETF trade—is the underlying liquidity of the ETF. The secondary markets—where the ETFs themselves trade, represent a second layer of liquidity. The secondary market is driven by both retail and institutional investors that are able to create and redeem shares to meet demand. Advisors shouldn’t worry about the lack of liquidity as market makers are on call to ensure that there is adequate liquidity available for both buying and selling pressures in the market.

The benefit of trading transparency

The advisor I was speaking with also expressed concerns about executing large volume trades with an ETF that typically has low volumes. I responded by asking if he knew the current spreads or volumes of the mutual funds he uses. Of course he didn’t. I told him that with either products, when buy and sell orders are executed, one trade is based on the current market prices and one at the end of day NAV. The benefit of an ETF is that it provides the daily transparency of what the underlying constituents are worth, and having the ability to participate when the markets are open versus waiting at the end of the day to participate in a traditional mutual fund structure.

As mentioned with the liquidity myth above, as long as underlying stocks or bonds are liquid, the ETF will not encounter any trading issues even in a low volume environment. I have seen large ETF trades with little or no volume trading without impacting the market. However, when the underlying securities are less liquid, naturally the spreads will widen out.

Mutual Funds and ETFs aren’t quite as different as some advisors initially believe. They can both work in your client portfolios, it really just comes down to how you run your practice. If you’re an advisor who is also looking to incorporate ETFs into your practice, but are looking for guidance, please reach out to your Franklin Templeton sales contact. They can help answer your questions about how ETFs can be incorporated into your portfolios.

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What Are the Risks?

Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

Ahmed Farooq’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.