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Are There Better Choices Than Mutual Funds?

We look at the pros and cons of the investment vehicles gaining traction.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Mutual funds have enjoyed tremendous growth during the past few decades, but other investment vehicles are gaining attention. Joining me today to discuss the pros and cons of some of these products is Russ Kinnel. Russ is Morningstar's director of manager research and editor of Morningstar FundInvestor.

Hi, Russ. Thanks for being here today.

Russ Kinnel: Glad to be here.

Dziubinski: Now in a recent issue of FundInvestor, you scored various investment vehicles on a handful of traits, things like costs, transparency, and diversification. Tell us a little bit about the traits you were looking at.

Kinnel: I'm just interested in some of the key differentiators between all these investment vehicles because I think investors are facing more and more vehicles. So, I looked at cost, transparency, regulatory structure--really just to kind of get at what are the key drivers of differences because I think now more than ever people have a lot to evaluate because there are more and more choices out there.

Dziubinski: And looking at your results, it looks like ETFs in general scored pretty well across most of those traits. Is that right?

Kinnel: It really is. They're great for liquidity, transparency, generally fees. There are some higher-cost ETFs, but generally ETFs are following passive strategies, and there are some very cheap ETFs. And then, on top of all of that, ETFs have some favorable tax structures that make capital gains distributions pretty uncommon. There's a lot going for ETFs. It's not an accident that ETFs have taken in so much money.

Dziubinski: And let's talk a little bit about collective investment trusts, or CITs. These are gaining traction among 401(k) plans and, of course, government-sponsored retirement plans. How did they look?

Kinnel: They are a lot like mutual funds. You have typically the same managers pursuing the same strategies of a diversified portfolio. But they have a different regulatory structure, which is a little less demanding, and therefore that means that they can be a little cheaper. And so, that's why you're seeing 401(k) plans switch, and you see a lot of Fidelity or T. Rowe Price where they have almost identical CIT to one of their big core equity funds. And so, you can get them for a little cheaper. Really, the biggest downside is there's a little less transparency on portfolios and if you enter all of your holdings into a portfolio tracker, you may not be able to put that CIT in there. So, you have to use the proxy mutual fund. So, it can be a little annoying to some people. But obviously, there's a cost benefit. And if it's a T. Rowe or a Fidelity clone of a mutual fund, you know what you're getting, really.

Dziubinski: There were two vehicles in particular, variable annuities and hedge funds, that didn't score particularly well throughout some of your metrics. Can you unpack the pros and cons of those two investments?

Kinnel: Yeah, two very different investments. Obviously, one is sold on safety and the other is kind of meant to be cutting edge or a strategy that will hold up well on a down market, but I think the underlying weakness of both of them is costs. A typical hedge fund might charge 2% of AUM and 20% of profits. Variable annuities typically have very big commissions. If someone is trying to sell you a variable annuity, it might be a good deal, but they're probably getting a pretty hefty commission on it. So, you want to look very closely. And my other issue with hedge funds is simply that generally the best ones go to the big institutions. So, even if you're an investor with enough money to get into a hedge fund, generally those for the masses or even the relatively wealthy are the second- and third-tier hedge funds. You may be getting Ritz-Carlton prices but a Motel 6 quality of hedge fund. I don't think hedge funds are great for a lot of individual investors.

Dziubinski: And then lastly, how did mutual funds stack up?

Kinnel: Mutual funds, and I kind of use that as my base case versus everyone else, because I think they're the best known--mutual funds are particularly good, I think, at transparency, regulatory structure. There's very sound structure around mutual funds. Where they are not always as good is fees. There are some very low-cost fee funds, but there are some higher-cost ones. Most mutual funds are actively managed. So, that's the main reason they cost more than ETFs. But you certainly have to be careful with mutual funds. Mutual funds have some of the commissions embedded in them as opposed to ETFs. Costs are one element. Another is capital gains. The capital gains structure around funds is a little less enticing than ETFs. Again, an index fund is probably going to be fine from a capital gains standpoint. But you do see actively managed mutual funds tend to be less tax-efficient. So, if you're buying for a taxable account, ETFs or passive mutual funds are often the better idea.

Dziubinski: Russ, thank you so much for your time today and helping us sort through all these different investment products that we have to choose from.

Kinnel: You're welcome.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.