A while back I was at a dinner with a bunch of people. A fetching young lady and I started talking finances (Mr. Cheap knnoowwwsssss what the ladies like) and I referred to ETFs as the thinking mans mutual fund. My father, who has been an avid mutual fund investor for decades gave me a bit of a hurt look, and I felt bad (I didnt think he was listening to me).

I got talking to a buddy who, on the advice of HIS father, was hot-to-trot to invest in a Spectrum mutual fund. I told him to get a diversified group of ETFs instead pointing him towards Canadian Capitalists Tour of ETFs and Sleepy Portfolio (as well as Money Senses couch potato portfolio). When I told him that a diversified ETF portfolio should average a 10% nominal return over the long haul (this is retirement money hes looking to put away), he asked why hed settle for 10%, when the Spectrum fund had averaged 36% over the last three years.

One of the best things about teaching someone something is that your fundamental assumptions are occasionally questioned. It can be a great way to expand your understanding in a direction that you didnt even realize you were deficient in if youre unable to answer their question (in which case you should probably go educate yourself until you can answer their question).

My response to him started with the idea that past returns dont guarantee future returns. I talked a bit about mean reversion (the idea that often an area that has been recently hot may go into a slump in the near future, or an area that has been in a slump may take off). He agreed with this in theory, but then asked isnt the manager a smart guy who knows how to move in and out of areas to make lots of money, leading to an ongoing above-average market returns?.

I agreed that this was usually the story mutual fund companies liked to sell, but I talked about how research had shown that mutual funds UNDERPERFORM the market on average. Since people arent just randomly chosen to run mutual funds (these are all professional investors), it makes the whole system pretty suspect if the average PROFESSIONAL cant beat the market.

I followed this up with the problem of popular (high performing) funds attracting lots of money, and how its harder to get high returns once a fund gets too big. The basic idea is that if they find a good deal, they cant buy as much of it (as a proportion of their portfolio) as a small fund could. It may be worthwhile for an individual to shop at garage sales for bargains, but it doesnt make sense for Walmart to do this (they wouldnt be able to find enough bargains to stock their shelves).

Following closely on the idea of big funds having trouble outperforming the market, I talked about how mutual fund companies start a large number of incubator funds. They let the managers of these small funds take whatever crazy risks they want. The hope is that some of their funds will wildly outperform the market (and, of course, if you have enough funds doing different things some will), they then promote that fund as their flagship product, promote its amazing returns in all the financial papers / magazines, roll over the poorly performing funds into it (and get tons of new investors in it). Since they know at this point they probably wont keep getting lucky again, they then track the market as much as possible (so they dont lose tons of money and annoy all the new investors), and prepare the next batch of mutual funds to create the hot fund of the future.

For some strange reason, these monsters funds tend to give you a return of [market expenses]. Isnt that curious :-).

At this point, ETFs offering [market small expenses] look appeals, and thats what I recommended buying. My friend still seemed somewhat hesitant, and I encouraged him to talk to his father further. I offered to buy him a copy of Four Pillars of Investing but he immediately told me under no circumstances would he read it. I felt kind of bad that I hadnt been able to convince him of the value of ETFs, but the next time I saw him I asked him if hed bought the Spectrum fund and he told me No, Im looking into ETFs.

For those who used to invest in mutual funds and stopped, what convinced you to bail on them? If youre a fellow ETF / Index Fund evangelist, what do you like to say to people to convince them to consider ETFs? If youre a mutual fund fan, which parts of this post do you think Im mistaken about (remember that youve got it ALL wrong, mister! is often a fair response to Mr. Cheaps rants).