ETFs vs MFs: How Diversification is the only free lunch

Diversification is the spreading of risk by investing in several categories of asset classes (e.g. stocks, bonds, commodities, etc.), across various industries and countries, or through Mutual Funds (MFs) and Exchange Traded Funds (ETFs). Buying MFs -- a collective investment scheme which buys stocks, bonds and other assets, and then sells shares to the public, is a way to diversify. However, most MFs such as the once market-beating Fidelity Magellan Fund (FMAGX) tend to underperform. The creation of ETFs in 1989 -- collections of similar assets that are traded like individual stocks on exchanges, provided investors a better alternative.

For the retail investor, ETFs offer several advantages over MFs. First, ETFs have lower expenses than MFs, which typically charge initial (can be as high as 5%), annual management (from 1% to 2%), performance (for positive returns over benchmark, no penalty for losses), and exit fees. MFs have a variety of costs (e.g. salaries, research, marketing, etc.); the seemingly negligible fees substantially reduce an investor's return. On the other hand, the buying and selling of ETFs incur low transaction costs (i.e. less than $10 through discount brokerages), and ETF annual charges are much lower. Also, ETFs are less prone to financial fraud (being traded publicly on exchanges), whereas MFs are purchased at set prices after exchanges close, creating the risk of legal or illegal arbitrage. Further, ETFs are usually more tax-efficient in the same categories. Additionally, ETF trading provides opportunities to short sell, buy on margin, and purchase options -- lucrative to high-risk investors.

While both fund types do not guarantee performance and are often not insured, they face certain limitations: MFs require more cash holdings (almost 0% interest) due to withdrawal unpredictability; ETFs may suffer from inactivity, low trading volumes, and offer lesser choices. Both face economic, market, interest rate, inflation, industry, political, and other forms of risk. Still, within the same investment categories, ETFs usually return better than MFs.

There are a number of reasons why 80% of professionally managed MFs underperform. First, if an MF had exactly the same portfolio as an ETF (i.e. closet indexing), it would do worse simply because of its exorbitant fees. Next, the high portfolio turnover of MFs caused by its more active investing approach results in more research and trading costs, unlike the relatively passive ETFs, which merely track an index. Moreover, since people tend to choose stocks they are familiar with, there may be human bias among MF portfolio managers.

FMAGX has consistently underperformed the S & P 500 and its category for the past 10 years and is now rated 1 out of 5 stars by Morningstar. Its slump began after star manager Peter Lynch departed in 1990 and worsened with the bursting of the 2000 tech bubble (due to its heavy weight on Information Technology stocks). Performance may have been affected when it deviated from its investment objective to invest in large-cap growth stocks, since it currently has 24% medium and 9% small-cap stocks. FMAGX's over 90% allocation to developed markets also caused it to miss out on growth in booming Emerging Markets and the BRIC (Brazil, Russia, India, and China) countries. A fourth reason could be fund manager turnover. FMAGX has changed managers five times since Lynch's departure. Different managers bring different strengths, weaknesses, and varying investment strategies. Lastly, Fidelity's employees may have been influenced by more than $1.6 million in perks from 2002 to 2004, including World Series and concert tickets, and trips to exotic destinations.

After considering investment horizon and risk profile, one should decide on the type of assets, nations, regions, and sectors to invest in, then choose the ETF that closely matches those objectives. Had one invested in SPY (S & P 500 index ETF that returned 2.82% per annum) over FMAGX (0.14% per annum) the past 10 years, a $10,000 investment would have gained approximately $3,065.28 more. That is money much needed in these dire economic times!