14 Funds that Are Better than ETFs

As one of Morningstar's ETF specialists, I've often noted that some conventional mutual funds often stand up quite well to the cost and tax challenges posed by exchange-traded funds. To that assertion readers often respond, "Oh yeah? Name them." It's time for us to put up or shut up.

We acknowledge that ETFs are cheaper and more tax efficient than most traditional mutual funds, but they don't trump them all. In fact, it's fairly easy to find a list of no-load conventional open-end mutual funds in our nine style boxes that can compete with ETFs on costs, tax efficiency, and performance. To find them, we screened for open no-loads with better five-year tax cost ratios and tax-adjusted returns than the average ETF in their categories. We also looked for funds with expense ratios that were, if not as low or lower than rival ETFs, at least lower than three fourths of other no-load offerings in their market-cap ranges. What follows is a list of funds that not only have given ETFs a run for their money, but also should be able to continue to do so because of their managers and strategies. If you buy these funds you may have to give up the vaunted trading flexibility of ETFs, but that doesn't matter as much if you measure your holding periods in years rather than days or months. And the beauty of these funds is that--unlike ETFs--you can buy them without a brokerage commission.

Index Alternatives
Several index funds made the cut. Fidelity Spartan Total Market Index  has a strong record of tax efficiency and an ETF-like expense ratio of 0.10%. Several Vanguard index funds, including Vanguard's  Total Stock Market Index (VTSMX),  Growth Index (VIGRX),  FTSE Social Index (VFTNX),  Mid Cap Growth (VMGRX), and  Extended Market Index (VEXMX) funds all overcame slightly higher expense ratios than some of their ETF peers to post better after-tax returns and tax cost ratios than the typical ETF in their respective categories. Small growth ETFs, such as  iShares Russell 2000 Growth Index  (IWO) and  iShares S&P SmallCap 600 Growth (IJT), also have shown no cost or tax advantage over  Vanguard Small Cap Growth Index's (VISGX).

The Tax-Managed Route
 Vanguard Tax-Managed Small Cap (VTMSX) and  Vanguard Tax-Managed Capital Appreciation  are particularly compelling alternatives to ETFs that ply the same part of the market. These funds, managed by Vanguard's quantitative equity group, have avoided capital gains distributions and minimized taxable income by harvesting tax losses and avoiding the highest-yielding stocks in their benchmarks. They have been quiet and effective. They both have attractive five-year tax-cost ratios and better tax-adjusted returns than most conventional and exchange-traded funds in their categories. Their 0.14% expense ratios also cede little ground to their ETF rivals. In fact Tax-Managed Small-Cap is the cheapest small-cap fund available to retail investors. There are a couple catches, though. The funds have high minimum investments ($10,000) and charge a 1% redemption fee on shares sold within five years of purchase.

Good Stewards, Quality Managers
It's probably no coincidence that funds run by managers who have substantial sums of money on the line with their investors also compete well with ETFs. High ownership by management gives these skippers incentive to stick around and pay attention to costs and taxes. Chris Davis and Ken Feinberg have millions in  Selected American Shares (SLADX) and manage their fellow shareholders' capital like it's their own. They take the tortoise approach, relying on patient, meticulous research to get to know companies. That helps them discern between value traps and opportunities and stay the course over the long term. Over the long term the fund's absolute and tax- and risk-adjusted returns have trumped ETF rivals such as the  SPDR (SPY).

 Bridgeway Ultra-Small Company Market's (BRSIX) manager John Montgomery also has an investment in this fund and others in the Bridgeway family. The fund invests in the smallest 10% of stocks on the New York Stock Exchange, much as a small-cap index fund might do, but Montgomery harvests tax losses to offset gains and holds some stocks as they exit the benchmark to control transaction costs and taxes. Expenses are not Vanguardian, but low enough to make this fund a better option than micro-cap ETFs, such as  iShares Russell Microcap (IWC) and First Trust Dow Jones Select MicroCap (FDM) for dollar-cost averagers who want exposure to this volatile corner of the market.

 ICAP Select Equity's  Manager Rob Lyon and his team have millions invested in this fund, and though it is different sort of animal, we like its chances versus competing large-value ETFs. Lyon and his team run one of the few funds that deftly melds macroeconomic and bottom-up research. He also includes many foreign stocks and turns the portfolio over much more than the typical large-value fund, which could make it less tax-efficient in the future than it has in been in the past. Yet Lyon and his squad are committed to their relative-value strategy and have delivered strong results. Its 0.80% expense ratio is higher than all other large value ETFs, including  iShares Russell 1000 Value (IWD), but so are its tax- and risk-adjusted returns.

Keep It Simple
The ownership levels at  American Century Equity Growth (BEQGX) aren't as impressive as at some of the aforementioned offerings, but a deliberate, disciplined process and relatively low expenses work in this fund's favor. Its managers try to gain an edge on the S&P 500 with quantitative stock-picking models. That's easier said than done, but the fund's managers work diligently to keep its models ahead of the curve and use their quantitative acumen to analyze the tax implications and transaction costs of every trade.

 Fidelity Blue Chip Growth's (FBGRX) experienced management and decent costs have kept its returns competitive with and volatility lower, as measured by standard deviation, than most large-cap growth ETFs. Managers John McDowell and Brian Hansen focus on established, profitable companies and shun edgier ones, giving a portfolio that befits its name. The portfolio's average market cap is higher than most rival ETF's, and includes large positions in household name stocks, such as  Wal-Mart (WMT) and  Microsoft (MSFT), that have been out of favor in recent years despite posting decent earnings growth. That makes the fund a good candidate for a core holding, as well as a play on out of season stocks.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.