When it comes to investing, there are many factors that guide a confident decision to buy. In addition to core principles, mutual funds and exchange traded funds (ETFs) have differing structures that make choosing how to invest a layered decision. In this article, we will explore due diligence considerations that apply to all funds, as well as several that are specific to the fund structure. [1]
Core Principles for Any Fund
Choosing a fund should begin with the investment strategy, which drives the type of structure that makes sense for a client. Risk tolerance, financial situation, goals, and time horizon all influence this decision. It is crucial to know what is inside of a fund before buying so that investments align with the investment policy statement (IPS). What does it cost to own or trade a position? An asset category tells you very little. Structure, cost, and fund construction tell you a lot more about what a mutual fund or ETF will do for your portfolio. [2]
Across mutual fund and ETF investing, observing a fund’s label is not enough to make a sound investment decision. Two funds in the same category can hold very different things, which drives varying performance. Analyzing funds effectively includes looking under the hood to identify the holdings, index methodology, and constraints that characterize a fund. Utilizing tracking error is a good way to see if a fund follows what it claims to follow, but further analysis of a fund’s structure reveals more about what an investor truly owns. [3]
Beyond Market Cap: There are different investment options for each market cap (small, mid, large), but the composition of these funds can vary significantly. Differences in index construction and inclusion rules drive different outcomes, even among funds in the same asset class. Russell 2000 and the S&P 600 are different small-cap mutual funds, but they have different holdings and are tied to unique inclusion and construction processes. Methodology differences explain why these returns vary and help investors make educated buy decisions. [2]
Value & Growth: Value funds seek bargains through trading at a share price that doesn’t reflect fundamental worth, and in an ideal scenario, the market properly recognizes the company’s value and prices rise over time. Value funds don’t prioritize growth, and even if the fund fails to appreciate, investors typically receive dividends. Value funds have less upside than growth funds, although this tradeoff comes with decreased risk. Growth funds prioritize companies that are expected to grow faster than others through profits, revenues or cash flows. Contrary to value funds, growth funds do not see dividends, but there is higher upside potential and increased risk. Growth and value large-cap funds have performances that differ materially over time due to different investment objectives, despite being listed under the same asset class. Blend funds mix both styles. [4]
When considering the costs of ownership, some fees are a known, recurring drag on returns (ex. management fees). Passive strategies are usually lower cost than active strategies, which makes mutual funds and ETFs a popular approach given their historically strong results in comparison. When analyzing fees, it’s important to ask what you are paying for, and whether you are receiving the benefits these costs should come with. [5]
Past performance is tricky to consider when choosing a fund. Long-term performance is a stronger indicator of how a fund will perform in the future than short-term performance. Very few top performing funds stay there for an extended period (strong short-term performance isn’t a sign to buy), and while some underperforming funds will bounce back, others continue to struggle. It is easy to rationalize why looking at recent performance could be a strong indicator of how future returns will look, but it is more effective to focus on long-term trends when looking at historical data. [6]
Mutual Fund Considerations
Costs and fees can impact performance significantly on mutual funds. Transaction fees during trading may seem like a small dollar amount, these costs can have a major influence on performance. A $25 trade fee on a position that trades quarterly is an annual cost of $100. On a $1,000 position, that would be 10% of the return going towards fees, which is the performance hurdle that must be cleared before the investor sees a return. An effective analysis of these fees is crucial to sound investing. [5]
Front-end loads are fees that investors pay when they purchase fund shares. Back-end loads are fees that are paid at redemption and are typically calculated based on the lesser value of the initial investment and the redemption. The most common type of back-end load is the contingent deferred sales load, where the fee is dependent on how long the investor has held shares (and typically decreases to $0 if held long enough). However, funds lacking transaction fees often charge higher ongoing fees. The same mutual fund can be sold in multiple share classes at different costs, and it is important to know which class you are able to own. Retail share classes often carry 12b-1 fees, which is an annual marketing or distribution fee included in the expense ratio. [5]
ETF Considerations
ETFs trade like a stock, where pricing happens throughout the day rather than once at closing, with trade fees varying by broker. The bid-ask spread is an implicit cost (not shown on statement), but this is a real cost that is paid every time an ETF trade is made. The bid price is the highest price a buyer will pay, and the ask price is the lowest price a seller will accept. For example, if an ETF bids at $100 and asks at $101, the bid-ask spread is $1. [7]
A key metric to consider when evaluating ETFs is the difference between implied liquidity and actual liquidity, which are two very different numbers. Implied liquidity reflects the underlying holdings and the ETF creation and redemption process. An ETF’s actual liquidity is tied to the liquidity of the stocks or bonds it holds, not just the ETF’s own trading volume. In practice, this means ETFs often trade tighter than what appears on the screen, with market makers often quoting for a better price once an order is sent. An understanding of market depth aids in this investment decision by showing the full order book. For example, this prevents risks of filling at progressively worse prices in a large quantity order. [8]
Key Takeaway
Selecting funds can seem simple on the surface but is a complex decision in practice. At Alaska Wealth Advisors, we partner with institutional partners to select investments that are held within client portfolios. This approach allows our advisory team to have the support of decades of robust investment processes while we focus on what matters most: crafting sound financial plans and investment strategies tailored to our clients’ goals.
Ben Duhrsen
Private Wealth Investment Analyst
This material reflects the author’s opinion, is not intended to be investment, tax, or legal advice, and is provided for illustrative purposes only. Alaska Wealth Advisors is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Alaska Wealth Advisors’ investment advisory services can be found in its Form ADV Part 2 and/or Form CRS, which is available upon request.
Sources:
[1] Edward Jones, “What Are Mutual Funds?”
[2] Raymond James, “Fund Selection Process” (PDF)
[3] ScienceDirect, research article on fund selection and performance
[4] Fidelity, “Two Schools of Investing: Growth vs. Value”
[5] Fidelity, “Mutual Fund Fees and Expenses”
[6] Fidelity Viewpoints, “How to Pick a Mutual Fund”
[7] Investment Company Institute, “ETFs: Frequently Asked Questions”
[8] Franklin Templeton, “The True Liquidity of ETFs: Implied Liquidity”
