Systematic Relative Strength

Index Universe contributor Matt Hougan contends that they are. He suggests that the advantage for long-term investors is that ETF consequences are driven entirely by your own actions:

When you buy a mutual fund, you’re exposed to the actions of others. For instance, if you buy shares in the Growth Fund of America, and then half of the investors in the fund decide to redeem out of their positions, you will bear the brunt of the trading costs as the fund sells stocks to meet those redemptions. If any capital gains are incurred, you will pay those gains, even though you didn’t sell a share and had no intention of exiting your position.

If, on the other hand, no one sells, but another $10 billion in investor cash comes into the fund, you have to pay your share of the costs of putting that money to work: the commissions, the trading spreads, the market impact, etc.

With ETFs, the only thing that matters is you. Outside of a small number of bond funds and a few alternative asset products—such as Vanguard’s ETFs, which share classes of broader mutual funds— existing investors are completely shielded from the actions of others either entering or exiting the ETF. No paying for other people’s commissions, no paying for other people’s market impact and, by and large, no capital-gains distributions driven by the actions of others.

Your investment return and tax profile are driven by your actions, and that’s it.

ETFs are great. We love them, but I don’t think the issue is quite so black and white. First of all, I’m not sure ETF investors are entirely shielded from other people’s market impact. Creation and redemption of new units could put unseen pressure on the underlying securities and might have some impact that way. The tax efficiency of most ETFs is certainly a plus, but they aren’t nearly as efficient for dollar-cost averaging as mutual funds are. Automatic investment plans-something a lot more investors should probably be using-where a fixed amount goes into a fund each month is one area in which mutual funds really shine. As with most investment products, it really depends on their use and your needs.

And then there is Mr. Hougan’s mention of the nearly mythical long-term investor! This failing obviously can’t really be attributed to the ETFs or the funds themselves. It’s a mistaken belief on his part that lots of investors like this exist. There is a marked tendency in both vehicles for investors to buy near the highs, sell near the lows, and have a holding period that is far too short.

DALBAR’s research suggests that the average mutual fund holding period is only 3-4 years, even for bond funds! Every advisor has a tale of the self-reported ”long-term investor” with a 7-10 year time horizon (on the consulting department paperwork) that pulled the account after the first down quarter. The truth is that almost any winning stategy will deliver great rewards over a long time horizon, regardless of the investment vehicle, whether it’s an ETF, mutual fund, or separate account. Find a manager that exposes a portfolio to a reputable return factor, executes the strategy in a discplined fashion, and hang on for dear life.