We Study Billionaires - The Investor’s Podcast Network - TIP 016 : ETFs or Mutual Funds? We ask MorningStar Expert (Investing Podcast)

Starting point is 00:00:00 This is episode 16 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish and Sting Broderson. All right, how's everybody doing?

Starting point is 00:00:29 Hopefully you had a Merry Christmas out there. and today we've got a special guest for you, and his name is Alex Brian, and he's an analyst covering passive strategies on MorningStars Manager Research Team. He's led teams of analysts and covers U.S. value, growth, and material sector funds. Prior to assuming his current role in 2012, Brian was a project manager with Morningstar. He was also a senior data analyst and oversaw in the launch of Morningstar's benchmark data service by acting as a liaison between China and institutional clients back here in the United States. He holds a bachelor's degree in economics and finance from the Washington University and graduated

Starting point is 00:01:08 Magna Cum Laude. And he also holds a master's degree in business administration with high honors from University of Chicago's Booth School of Business, which is an outstanding school. So I think we can confidently say that Alex really knows what he's talking about, and we are very excited to have him on the show to talk about finance and investing securities. So, Alex, one of the things that I really like to do is separate my broker from my analyst tools and resources. And so with that said, I'm a huge fan of Morningstar. I use Morningstar all the time because I don't feel like I'm getting biased information and feedback and like some brokers trying to sell me something.

Starting point is 00:01:45 I feel like I'm getting very unbiased information. And so for anybody out there listening, that is my primary resource. I think that the Bloomberg terminal is a little overpriced at 30K. So I think Morningstar offers a good solution to a lot of people out there, provide some good resources. And so we're very excited to have you on the show in representing Morningstar. So I wanted to throw that out there. Thanks for having me. So what we'll do, Alex, is we'll just kick this off.

Starting point is 00:02:12 And Stig has the very first question. So go ahead and fire away, Stig. So, Alex, you're really thrilled to have you. And you should probably know that one of the reasons why we were so big on having you was that you are expert in ETFs. So a lot of people probably heard about ETFs, a lot of people probably heard about a mutual funds. And it might not be reasonable to say what is the difference between ETFs and mutual funds because there are so many and there are coming so many priorities. But if you can just draw up the big lines, so why should I invest, for instance, in an ETF and not in the mutual fund?

Starting point is 00:02:47 Sure. So let's first start out by comparing how an ETF and a mutual fund work. With a mutual fund, an investor will basically give money to a fund company to manage. In return, the investor receives shares in the fund. The portfolio manager then uses that money to purchase individual securities for the portfolio. When an investor wants to take money out of that fund, the portfolio manager may have to sell securities in the portfolio to raise cash for the investor. This could force realize capital games, which the fund is then required to distribute to all of its investors. So even if investors don't sell their mutual fund, they can be hit with capital gains tax liabilities.

Starting point is 00:03:29 And that's true of any capital gains that a fund realizes. So mutual funds don't tend to be the most tax-efficient vehicle. They also have to maintain individual client account records, which can increase their administrative expenses. Now, in contrast, an investor who wants to purchase an ETF usually does so from another investor on an exchange. So the fund company doesn't get involved. And that improves tax efficiency because if I decide to sell my shares in the ETF, the portfolio doesn't have to sell securities in the portfolio to satisfy my cash needs. They also don't need to maintain individual client accounts, and that can reduce their administrative

Starting point is 00:04:07 costs. So there's two benefits of ETFs over mutual funds. One, they tend to be more tax advantaged. And two, they can potentially be lower cost. And you know, it's funny. Stig and I are reading this book on Tony Robbins right now. Now, kind of a long read for, I think, the content that's in it. But in general, there's some nuggets in there that I found really interesting.

Starting point is 00:04:27 And one of them was this idea of, I mean, he just pounds mutual funds in this book and how much worse they perform than a regular index or ETF, like you're saying. And he says that 96% of actively managed mutual funds underperform the market. And just, I mean, that number is huge. 96% underperform the market. He says, additionally, 49% of fund managers don't even have a dollar in the funds that they're managing. Do you see more and more people stepping away from mutual funds and do you see them as a dying financial instrument as we move into the future? The percentage that you cited of actively managed funds that underperform the market seems a little high to me. Actually, based on Morning Start data, I found that 27% of active managers in the large blend category outperformed the S&P 500 over the market.

Starting point is 00:05:18 past decade. Now that's still pretty low and that's before taxes. You know, so index investing does tend to be more tax efficient than active management because it requires a lower turnover. So after taxes it's likely that even fewer than 27% outperformed. After you adjust for risk and style tilts, which investors can replicate with an index fund, even fewer active managers show any evidence of skills. So I think that that 4% are the 96% figure that you cited of managers who underperform the market, that's probably adjusting for things like style tilts and the amount of risk managers take. But in any case...

Starting point is 00:05:56 Yeah, I agree. I think that it was adjusted for all those factors. Right. But in any case, there's a lot of evidence that suggests that active managers in general have a very difficult time of outperforming the market. In order to understand why, it's important to understand that active management is a zero-sum game. So in order for one investor to outperform the market, someone else has to underperform. So in aggregate, because active managers or active investors are defining the market,

Starting point is 00:06:25 before fees, their asset weighted performance should be very similar to a representative of indexes. But after fees, because active managers charge more than an index fund does, they should lag on average. And I think that's why you see most active managers underperforming their index. And the thing I think a lot of people don't realize is when you're at one or two percent difference from what the market's performing and then you compound that over a 30, 40 year period, you're talking hundreds of thousands, if not millions of dollars for people. And I really think that it's very delusional for a lot of people because they're like, oh, well, it's just a 1% fee that I'm paying for somebody to actively manage my fund. And they don't really realize that, A, he's not outperforming an index. And B, that 1% really adds up to. to a lot of dollars in the long run. So, yeah, that's some very interesting points. Absolutely. And also, I'd like to mention that, so this distinction between active and passive is an important one.

Starting point is 00:07:24 And I think there's a really strong case to be made for taking a passive approach to investing because of these cost savings. But that's not the same thing as saying that mutual funds as a vehicle don't have any future left in them. In fact, I was looking at the flows into mutual funds, looking at the, uh, looking at, uh, the division between active mutual funds and passive mutual funds, and actually passive mutual funds, funds that track an index, have actually had a lot of money flowing into them,

Starting point is 00:07:51 while active mutual funds have had a lot of money flowing out of them. So investors, you know, it's not really an important distinction, whether you go with the ETF vehicle or the mutual fund vehicle. It's a more important distinction, whether you go of an active strategy or a passive strategy. Now, it's true. Most mutual funds do tend to be actively managed, but there are some good low-cost passive index mutual funds that are available to investors. Yeah.

Starting point is 00:08:16 Yeah, and I think that that's become really popular in the last, I know back in the 90s, you'd have to pay 2 and a half percent just to get into a mutual fund, then you'd have another 2% annual fee. I mean, it was just crazy. And I think that because of the competitive nature, and I think that so many people realize that a lot of these mutual funds are not outperforming an index or the market in general, that they've had to bring those fees down

Starting point is 00:08:40 or else that it was just going to be a total collapse of the whole vehicle, the mutual fund vehicle. But hey, Stig, go ahead and go with the third question. Okay, Alex, so while most active managers don't upperform after fees, there are a lot of ETFs that deviates from market cap waiting in an attempt to upperform traditional indexes.

Starting point is 00:09:00 Do any of these funds have any merits? Sure. So, you know, there are a few strategies that have historically worked well in nearly every market studied over long-time horizons. So I'll briefly summarize some of these. So there's value, buying assets that are cheap. You know, Warren Buffett is known for doing that. There's quality, buying stocks with strong profitability and stable earnings.

Starting point is 00:09:25 Low volatility, buying stocks that haven't moved around a lot that tend to be more defensive and can weather the business cycle of grace. And that's related to quality to a certain extent. And then there's momentum, which is buying assets that have recently outperformed. Now, there's a long and interesting literature on why these strategies work, but most explanations center around risk. So, you know, a strategy of buying stocks that are cheap could be, in fact, taking on more risk.

Starting point is 00:09:53 And so you would expect to be compensated for that risk in the form of higher expect returns. So, for example, a company like Sears may look very cheap, but there's a risk that it could become cheaper or go out of business. So if I buy a portfolio of stocks that are cheap, I may expect to earn higher returns for taking on that risk. The other explanation is that there could be behavioral biases that create mispricing in stocks. So investors may extrapolate past growth too far into the future, and that could potentially

Starting point is 00:10:21 push prices away from their fair value. So if investors are really excited about what's going on with Amazon, vaults growth, they may be willing to overpay for the, in order to purchase Amazon. Similarly, they may neglects kind of the more boring solar growing stocks like Hewlett-Packard or Lexmark. Investors should look for funds that charge significantly less than actively managed alternatives and that have a simple, transparent methodology. Complexity is often a sign of data mining. Remember, there's only a handful of strategies that have been really well vetted by the academic community, and those are the ones that I mentioned.

Starting point is 00:10:59 So if you're looking at a strategy that does something more complex, it's where you're being skeptical of that strategy. Also, it's important to remember that a lot of times there are similar alternatives that offer comparable exposure for a lower fee. So we'd like to see transparency. We'd like to see low fees with these smart beta ETS. Let's take a quick break and hear from today's sponsors. All right.

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Starting point is 00:15:36 ETFs, that was risks. So you're saying that might even be like lower risk, it might be higher risk. But how do you define risk when you're talking about something like an ETF? It's a great question. So there's a lot of ways to define risk, but I think the most useful is probability of loss and magnitude of loss when it does occur. you know, it's difficult to get a handle on how you measure risk. One way we like to look at risk is volatility, so looking at how much an ETF or a fund moves

Starting point is 00:16:08 around. The more volatile a fund is, but why are the dispersion and possible outcomes, so the greater the probability of loss is. Another way that a lot of investors look at risk is tracking error or the risk of underperforming the market for an extended period of time. Now, when you take any of these smart beta type bets, such as buying stocks that are cheap, there's a risk that, you know, these things, even though, even if they work well over the very long term, they can underperform for many years.

Starting point is 00:16:36 So if I'm an investor in these strategies, I have to be comfortable with that risk of potentially underperforming during a potentially bad time. You know, value, it looks really great if you go all the way back to the 1920s, but during the financial crisis of 2008, 2009, value strategies underperformed. form because they were overweight and financials. So you have to be comfortable with these risks that you're taking on and really have a long-term horizon to profit from them. Yeah, that last part is the real important part. I think a lot of people, they think, oh, I'm making these decisions, and I'm going to hold it for five years, and they think that that's long term. But I think that, you know,

Starting point is 00:17:12 you look at a guy like Buffett and Charlie Munger and all these other just amazing financial investors that use a value approach. I mean, they're truly buying it to own it forever. They're buying it as an equity purchase and they don't ever plan on selling it. So at last point, it's very important. Yeah, and keep speaking about risk, and this is really an interesting topic. Alex, would you say that by investing in ETS, which is like hundreds of companies, you are actually limiting your risk, partly because you are investing in a huge amount of companies, but also because you might be buying ETFs in larger companies that might be

Starting point is 00:17:49 less risky. Absolutely. So to the extent that stocks in a portfolio are not perfectly correlated, you can reduce your overall risk by combining them in a portfolio, right? So that's because these stocks, their volatility can offset one another to a certain extent. So let's take a really simple example. Let's say you have two companies. One just makes sunblock, another just makes umbrellas. The umbrella company is going to have a lot of sales at a time when the sunblock company was. is going to have low sales and vice versa. So this idea of combining stocks into a portfolio is useful from that perspective. You tend to offset your gains and losses by having a lot of different companies that are not perfectly correlated with one another. So an ETF is useful because it reduces this risk. It spreads this risk out among a large number of companies.

Starting point is 00:18:45 Now, there's a lot of different ways that you can make targeted bets of ETFs. So there's ETFs that target small-cap stocks. There's ETFs that target the broad market. Anytime you're deviating from a broad-market ETF, you are taking on potentially more risk. So, for example, investing in a small-cap ETF will tend to be more volatile than a large-cap ETF. And that's because small-cap companies do tend to be more sensitive

Starting point is 00:19:10 to the business cycle than their large-cap counterparts. But in any case, diversification is always a good plan, no matter what you're doing. you're not paid to take on company-specific risk. So if I just hold one company in my portfolio, I'm taking a lot of risk that I could have diversified away had I held the stock in a broader portfolio. So that's not a necessary risk. I want to get rid of that risk to the extent that I can by using a diversified ETF or a diversified mutual fund. And I think for the audience, I think a lot of people need to understand that your most important thing you've got to do is protect your

Starting point is 00:19:47 principle. For these people that go out there and think that the most important thing to do is to get a 70% return for the year, that's fun and that's exciting and that's really awesome if you can do it in one year. But the fact of the matter is that person who can protect their principle and minimize their loss is probably the most important thing you can do. Because if you can grow it at 10 or 20% every year and on the down years, I only lose maybe to 3% that's a person who's really going to have an enormous amount of financial success

Starting point is 00:20:22 because typically the person who has that 70% year, the following year they have a negative 120% loss that they don't tell you about. So this discussion about risk mitigation, how do I protect my principle is something that separates professional investors, insiders from people that are just really amateurs and don't know what they're doing. So great discussion there. on the risk. Stiggy is something you wanted to say? Yeah, because I don't own any ETFs myself, but I think the whole idea of a passive madness ETF is that for most investors is a really good idea

Starting point is 00:21:00 because when you hear about these people who are making like espresso saying 70% a year, that is impossible if you own like an ETF, almost impossible because you might be only like 100 years. And these guys who are making like 70 or 100% a year, They might only be holding one or two, say a tech stock, for instance. So they're taking huge risk, which you don't see, you only see and hear about the returns. And as Preston is saying, you know, next year they might go broke.

Starting point is 00:21:27 Yeah. And actually, I can jump in. So absolutely mitigating risk on the downside, that's where that separates the professionals from the amateurs. You really, it's really difficult to overcome a large loss because, you know, a lot of investors don't have the emotional fortitude to stick with a portfolio through those painful times. And if you stick to an index portfolio, that can help take the emotion out of the equation. You don't have to worry about, you know, is this manager someone actually fire because they've underperformed in this year? You're really sticking with, you know, this broad-based index portfolio,

Starting point is 00:22:05 and that I think will serve investors well over the long term. Yep. Hey, so I got a question for you. And I know I actually do not like being asked these kind of questions. And so I apologize if you don't want to answer the first part of this question. I completely understand. But I'm going to throw it out there anyway because I'm just curious if you will answer it. If not, then we'll just focus on the second part.

Starting point is 00:22:25 So the question is this, what are your top two favorite ETFs and why? For example, maybe you could throw out there because of a certain expense ratio. They have a good track record. A bid ask ratio is good. Whatever. And if you're not comfortable naming that, we completely understand. But what would be your thought process? How would you go through kind of assessing it at a very generic and high level?

Starting point is 00:22:48 How would you go through assessing the pick of an ETF? So one of the funds that I like is Schwab U.S. dividend equity ETF, ticker S-C-HD, and that targets dividend-paying stocks with high cash flow relative to their debts, high return equity, high dividend yields, and a high five-year dividend growth rate. This gives it both a quality tilt and a value tilt, which may help it perform a little bit better than the market during downturns. So we talked about mitigating downside risk or reducing the risk of substantial losses. I think this is a fund that can help investors whether market downturns better than most. And as a result, that may help boost its long-term performance.

Starting point is 00:23:34 So those are some of the reasons why I like this particular fund. But one of the best things about this fund is this expense ratio, which is only seven basis points, are $7 for every $10,000 that you invest in it. That's comparably priced to a traditional S&P 500 index fund. So I talked about the importance of looking for smart beta funds that are not much more than traditional index alternatives. This is one which is priced right at the low end of your traditional S&P 500 index funds. So for those reasons, I think that's a pretty solid. like poor holding for investors in the U.S. In the international arena, I like Schwab fundamental international large company ETF,

Starting point is 00:24:15 ticker on that is F&DF. This focuses on developed market stocks outside of the U.S. And I think right now valuations in developed markets outside the U.S. are more attractive than U.S. market valuations. This fund basically weights its holdings based on fundamental measures of size, including sales, retained operating cash flows, and dividends plus share buybacks. This causes it to overweight stocks that are cheap and underweight stocks that are expensive relative to these metrics.

Starting point is 00:24:48 When this fund rebalances, it increases its exposure to stocks that have become cheaper against these metrics and relative to their peers, and it transfers to positions in stocks that become more expensive. So essentially, it's a value strategy, but one of the things I really like about it is it's one of the cheapest international value funds available. It does charge a 32, I'm sorry, a 32 basis expense ratio, which is a little bit more than what you would have to pay for a U.S. value fund, but in the international arena, it's one of the cheaper options available.

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Starting point is 00:28:56 not been around for 10 years. I believe they're both launched within the last, well, I know the Schwab Fundamental International Large Company Fund was just launched, I think, in the last year or so. The Schwab U.S. Dividend and Equity ETF has been around for, I think, four years or so. So we don't have a 10-year track record. We have the record of their indexes, and their index records have been good. But again, I like to discount back-tested performance and look at the lot of track record to the extent possible. But in any case, I think the strategies that these funds pursue is very reasonable. They're both taking a value tilt, buying stocks that are cheap, and historically, that strategy

Starting point is 00:29:39 has worked pretty well. The U.S. dividend equity fund also looks for high quality dividend paying stocks, stocks that have good profitability. These are stocks that tend to be a little bit more mature, a little bit more stable, and could potentially weather market down turns better than most. So I think the strategy is reasonable. The expenses are attractive, our expense ratios are low. So for those reasons, I would feel comfortable owning both of those.

Starting point is 00:30:02 And in fact, I do own both of these funds as full disclosure. Fantastic. That's phenomenal. And so for people, if you don't know what basis points are, so he was saying it was seven basis points. So if you're talking a 1% fee for this, it would be a 0.07% fee whenever you say it's seven basis points. Just to kind of give you an idea of how low the fees are on these funds that he's talking about. Okay, Alex, I mean, you're providing us just fantastic information here. This is awesome.

Starting point is 00:30:32 So this is a question that we like to ask all of our guests. What's the best investing advice you have ever received? So keep cost low. If you look at the evidence behind the link between expenses that you pay and performance, there's no clear a link. the higher your fees are, the less money you keep and the worst your performance is going to be. It's really important to keep costs low so that you can keep more of the money that you earn. That compounds over time and can give you a long-term performance edge.

Starting point is 00:31:06 That's one of the reasons I like Vanguard so much because they price all of their funds at cost. And I think that his investors are a long-term edge. But it's very difficult to beat a market capital. way to benchmark after fees. So I think it's really, really important just to keep cost low. I can't hammer that enough. Great answer, Alex. And in continuation of this, another question that really like to ask our guest is if there's any good books that they can recommend. And especially because you're an expert in indexes. Perhaps you have a good book recommendation about that. Absolutely. So the little book of Common Sense Investing by John Vogel, I think, is one of the best

Starting point is 00:31:46 books on index investing. John Bogle is the founder of Vanguard. And again, like I mentioned, Vanguard basically prices all of their funds at cost. The mutual fund owners in Vanguard actually own Vanguard itself, which is why it's able to do this.

Starting point is 00:32:02 But this book, the little book of Comincess investing, basically explains that active management is a zero-sum game. So it's a loser's game if you want to try to beat the market, because in order for one person to win, someone else has to lose and an aggregate there's no benefit to that.

Starting point is 00:32:19 The only way that you as an individual investor can really win consistently is by keeping cost low through a low cost index fund. So I think this book does a really good job of walking through that intuition and helping investors understand what some of those benefits are of owning a low cost index fund. Yeah, you're not going to find a better author than Bogle. So for everybody out there, I would definitely second. Alex's recommendation here with this book. So great recommendation. Hey, Alex, it was really fun having you on the show. We really appreciate you taking time out of your day to talk to our audience and just kind of share all the knowledge because you're just a wealth of information here. And we just really appreciate you sharing that with our audience. Absolutely. Thanks for having me.

Starting point is 00:33:06 All right. So it's that time where we're going to go ahead and answer one of the questions from the people in our audience. And so this question comes from Chris Shaw. And Chris says, I've listened to the book on Warren Buffett in the interpretation of financial statements, and it explains the importance of finding adorable, competitive advantage. In the very beginning, it states that you should really know accounting before picking stocks. How much accounting should be considered a full degree or what? So, Stig, what's your opinion? Well, Chris, it's really a great question. I think if you want to go into individual stock picks, I think you should be proficient in accounting and how much I'll just return to. But if you're more into ETFs as Alex, our guest was,

Starting point is 00:33:49 then you probably don't need to be as proficient in accounting. I think the problem about answering this question is that you cannot just put a value on that. I mean, you're asking, do you need to have an agree, do we need to have a degree in accounting? And no, you definitely don't need to have a degree in accounting. But how much do you need to know? Well, I would say that if you know how to read the income statement, the balance sheet, and the cash flow statement, if you can go through those three statements for a company and understand at least 95% of what's happening, I think you are probably well off.

Starting point is 00:34:28 And then when we're talking about key ratios, because there are so many investors that are big in key ratios, and I'm big on the key ratio as well. But I think it's really important that you understand how these key ratios are calculated and how they can be manipulated. So I think that would probably be my benchmark in terms of accounting proficiency. So understanding at least 95% of the three big financial statements and then the most common key ratios in how they can be manipulated. So I agree with Stig. I've got the exact same opinion. I think if you're investing in individual stock picks and you don't have a firm grasp on accounting, you're probably assuming a lot of risk.

Starting point is 00:35:10 I guess that's the best way I could say it. I know for me personally, my understanding of accounting greatly increased ever since I started my own business and I owned my own business. And I was actually creating an income statement. I was creating a balance sheet and I saw how money would flow from one statement to the other statement and how the cash flow statement worked. Whenever I started doing that myself, my understanding and my knowledge of it just went through the roof. And it just started really making a lot of sense for me. And I think for a lot of people, they don't own their own business. And so whenever they look at an income statement, balance sheet or cash flow statement,

Starting point is 00:35:44 it looks like an alien language to them. And they just don't really understand how it's all correlated. But it's like plumbing. Okay, the money flows from one statement over to the other statement. And you have to understand how that's linked and what it means as you look at statement to statement. And I guess I'm of the opinion. If you don't understand that fully and you're investing in individual stock picks, you're really assuming a lot of risk by doing that.

Starting point is 00:36:10 Yeah, and Chris, that was probably an even better answer that what I came up with, because it's really not enough that you know how to read an income statement. For instance, you need to know how that income statement interacts with the balance sheet and how the balance sheet interacts with the cash flow statements. So, yeah, Kristen, that was a great answer. Thank you, sir. Hey, so that's all we got for today.

Starting point is 00:36:33 We're obviously having fun here, and we really enjoy your questions. So if you guys have any questions, go to AsktheInvesters.com and submit your questions there. Record them. We really like recorded questions. So record your questions. Send those off to us. We're going to go ahead and put a free signed copy of our book, the Warren Buffett

Starting point is 00:36:49 accounting book in the mail for you, Chris, and we'll get that to you shortly. So thanks everybody for listening to us. And we really like to thank our guests for coming on the show today, Alex, Brian. And we'll see you guys next week. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest appearance to the investors podcast

Starting point is 00:37:15 by going to www.org.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before a commercial application. P-I-D! P-I-D!

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