Ep 15: Mutual Funds vs. EFT's: Why We Don't Always Choose the Cheapest Option

💭 "If one of your investment principles is reducing costs, why do you still use mutual funds when ETFs are cheaper?"
That’s the thoughtful listener question that kicks off this episode—and it leads to a wide-ranging discussion about value, strategy, and what really matters in long-term investing.

Join Landis Wiley and Allen Wallace as they unpack why cost alone shouldn’t drive investment decisions—and how institutional mutual funds, qualitative manager traits, and portfolio construction all factor into smarter investing.

 ✅ Why lower cost doesn’t always mean better value in investments
 ✅ The tradeoffs between mutual funds and ETFs, including manager oversight and turnover
 ✅ How Allen evaluates mutual funds using Buffett-inspired criteria
 ✅ The role of qualitative factors: manager passion, strategy, and team depth
 ✅ How Japan’s rising interest rates are affecting global bond markets and investor portfolios

🎯 Whether you're a DIY investor or working with an advisor, this episode offers clarity on how to evaluate investment costs in context, not isolation.

Key points: ETFs vs mutual funds, investment costs, active vs passive, portfolio strategy, Japan interest rates, fund manager analysis

We hope you’ve gained some valuable insights or maybe even a fresh perspective on our topic today. We would love to hear from you with your questions or specific topics you would like us to cover. Simply email us your questions or suggestions to info@basepointwealth.com and who knows, your topic might be featured next.

Be sure to subscribe to be notified of upcoming episodes. Visit www.basepointwealth.com for more information and important disclosures.

Transcript

The Point Podcast Ep 15 "Mutual Funds vs. ETFs: Why We Don’t Always Choose the Cheapest Option"

Welcome to The Point Podcast. We have informed, intelligent conversations about today's financial topics submitted by viewers like you.

Let's go ahead and get started. Here are your hosts, Landis Wiley and Allen Wallace.

Hello and welcome to The Point sponsored by Basepoint Wealth, I am your host, Landis Wiley, sitting here, as always, with our esteemed Chief Investment Officer, Allen Wallace.
  
I got promoted. All right, awesome. 
 
Well, we have an exciting podcast here for you today. We did get a question from one of our viewers, so looking forward to getting to that before we get to it, though. Man, a lot is going on, there is a lot in the news. It's been an eventful couple of weeks in the market. Just a lot of things happening. So, I guess let's just kick this off. What do we want to talk about in terms of the biggest thing going on in the news right now?

Well, so I don't think it's the most prevalent thing in the news, but the biggest thing is probably what's going on in Japan. You know, their longer end rates are starting to rise, which is causing a lot of problems for investors who have borrowed money, and then also for their own domestic insurance companies, who have large positions in 30 and 40 year bonds, they're really the one of the very few owners of those types of bonds. We saw what happened to 30-year bonds when rates rose. Well, imagine what happens to a 40-year bond. It's even worse, right? Because that duration is bigger the longer out you extend maturity. So, I know I sound like a broken record about this carry trade thing, or, you know, maybe the boy who cried wolf. But these things sort of just, you know, percolate beneath the surface, and they're like dynamite in search of a fuse. And the thing is, we don't know what the fuse is going to be, but we can see that there's a giant pile of explosives sitting there, and it may or may not ever explode, but you know, when it does,  people's reaction is to look around and say, Well, who could have saw this coming? You know? And so, if there continues to be pressure on Japanese rates. Traders are going to have to continue to unwind their trades, and the things that they own on the long side are the S&P500 and Bitcoin and all these other things that have been appreciating value. And if liquidity dries up, then you know, we could see some fireworks here, not guaranteed to happen, because nothing is, but it's something that we definitely need to keep our eye on, right? 

And the thing that's fascinating with Japan, you know, for 20, 30 years, everybody was kind of looking at them, wondering how they were being effective at holding their interest rates at effectively zero, right, right? You know, seemingly everything was going swimmingly well, implementing, I guess what modern monetary theory? Yes, MMT.

 But what's really happened is most of their government bonds have ended up on their central bank's balance sheet, right? So, what's left is sort of highly volatile. When rates fluctuate, the central bank doesn't care if rates go up, but insurance companies do,

right? And obviously, even small changes in interest rates when you're coming off of zero can make a big difference, right? We're not talking about rates going to five or 6% over there, at least not yet, right? You know, we're at what, one or two percentage points.

Yeah, so duration is how we measure a bonds fluctuation based on interest rates, and it's usually in numerical terms, like a duration of seven or something like that means that if rates rise, then you know the bonds are going to go down by 7% if it's a seven duration, and the lower the rate, the higher the duration, and the longer the maturity, the higher the great duration. So, we've got sort of a perfect storm there, 40-year bonds at rock-bottom interest rates. So, you know, they're kicking up both tails of the duration, right? So, it's something to keep an eye on. And there's been some in the headlines about that dynamic in Japan, even with China. And, you know, not being isolated to their own rates, but also kind of impacting potentially here as China and Japan are two of the largest holders of US Treasuries, right? Yeah. And in order to sort of keep their own rate environment under control, they need to be able to buy their own bonds, push prices up, rates down. In order to do that, they need cash. In order to generate cash, they're selling treasuries.

Yeah, yeah. I mean, we talked about this earlier. I think that China has reduced their treasury holdings by like half, and Japan’s have declined quite a bit too. So that definitely keeps the pressure on our long end. And the more our long end rises, the harder it is for the real economy, because that's what your mortgages and your car loans and your credit cards are all based upon, and mortgages are based on the 10-year. So, if the 10-year keeps rising, then it's going to make mortgage rates continue to go up, which makes housing affordable, you know, which starts to impact the real economy? So for folks out there that are looking for that reprieve from six and a half or so interest rates on mortgages Japan matters, yeah, yeah, I wouldn't be looking for 3% mortgages anytime soon, sure.

Yeah, well, be interesting to watch. I'm sure it'll be a continuing topic for us. Yeah, we'll try not to harp on it too much, right? Well, it's a big deal.

So, with that, should we jump into our question? Sure, I think it's a good one. It's been a while since we've sort of talked specifically about the principles, Basepoint’s investment principles. So, the question that we got today dives right into the investment principles, one of which is reducing costs right on investments.
 
 The most misunderstood principle.

So, we'll try to try to educate them. So the question was, if one of our principles is reducing costs, why do you in your investment strategy still use mutual funds, given that ETFs generally have significantly lower expenses?

Okay, so, well, first of all, the principle is to consider costs, not to reduce them. I would say we want to reduce unnecessary costs, but, you know, I could save a lot of money by living in my garage. But you know, there's a certain level of baseline expenses you need to have to run a successful business, right? So, it's not indiscriminately reducing costs. It's managing costs carefully and making sure we don't pay for things that we don't need, right?

Which, over the last 30 or 40 years, you know, with the rise of indexing, the creation and sort of proliferation of ETFs, the number one driving narrative that a lot of investors hear is low cost, right? Low cost, low commission, low fees. That's sort of been the foundational focus of a lot of people right is, how do I just pay less for my investments when you're talking about that not being the principal focus, you know, what are you looking for then,  if driving costs are a consideration, but it's not the focal point, what should the focal point be? 
 
 Well, we need to figure out what we're getting for our money. And if we buy an ETF, that's 30 basis point, you know, expense ratio. We're not getting any analysis. All we're paying for is for them to mimic the index and rebalance the portfolio. If we own a mutual fund, that's, let's say, .85 and we might be getting 13 analysts working for us, analyzing securities. So, I mean, there's a big difference in what we're getting for our money there. So, if you own a $50 billion mutual fund, there's only so many analysts they can hire, right? But when you own a $500 million mutual fund, having a couple analysts on staff is a fairly large percentage of the total expense ratio, yeah. 
 
 So really more looking at results, sure, it's kind of, yeah, exactly. I mean, we want to utilize security selection in order to try to stabilize our returns and possibly outperform the market in that one asset class. Right? The total portfolio is never going to outperform the market because it's made up of stocks and bonds and other things, but our large cap value fund definitely could outperform the S&P500. So, I think the problem is, we try to compare our entire portfolio to one index, and the portfolio itself is never going to beat just a large cap, you know, stock index, right? 

So what do you say? You know, what's your view on, there's been a lot of headlines over the years trying to assess the value of active management versus passive right, which, you know, I think is in large part connected exactly to this issue, right? Why? Why are you paying a higher internal expense fee on an active managed fund versus a passive one? You know, what's your response to that line of thinking?

Well, this is one of those things where you can give advice to the average person that isn't necessarily good advice for everyone individually, right? So, I think on average investors won't outperform their index. But that doesn't mean that none of them will. What the professors tell us is that you can't identify those people who do outperform, and if they do outperform, then it's luck, not skill. So, what we've tried to do is find a way to identify advanced managers that are going to do well, and then also try to identify who's doing it based on skill, not based on luck, right? And my mutual fund selection criteria goes back to a letter that Warren Buffett wrote to Katherine Graham in the 1970s on how to manage the Washington Post pension fund, right? And it's 19 pages long, the first half. Super boring. It's about like, you know, pension mathematics, but if you can make it through the first 11 pages and get to the end, Buffett tells us three things. When you're hiring a money manager, you want them to be small, because having a lot of assets is a curse. So, the bigger you get, the harder it becomes to manage money. You want to be concentrated. So you don't want to, you know, there's no sense in paying someone 80 basis points to manage a portfolio of 400 stocks. How much time are you really putting into each individual holding, you know, we try to stay in the 20 to 30 holding range. And then also, you want someone who's not turning their portfolio over too much, because trading costs are really expensive, right? And if you're making bad decisions then you have to unwind over again. You know, you're better off looking somewhere else, right? So, you want small, concentrated funds with low turnover, and that's sort of the table stakes for us, for a fund to even be under consideration. Those are sort of quantitative factors. But then there's also qualitative which is, what is their process? We're hiring the fund to manage a portion of our clients' assets, right? Just like any other employee. Mean, you don't just go into some sort of data service provider and sort by three-year performance. I mean, you're hiring, you're hiring someone for a position in your firm, right? And so, you know, we talk to the managers. We may visit their office. We know what their philosophy is. We read everything they write. We listen to their conference calls. We manage them just like we would manage an employee. And I think the problem is, you're looking at a world of 30,000 mutual funds, and you're saying, you know, on average, these all suck. How are you going to find one that you know that does a good job? And the point is, you have to, you have to treat it like any other employee. You can't, you couldn't expect to hire a random person off the street to do it, to do a job here, right? So, thinking about the average mutual fund, to me, is sort of, you know, kind of a unwise thing to do, right?

Well, and you made mention in there about that idea of concentration, right, of looking for funds that are holding 20 to 30 stocks, that's not the average fund.

No, the average fund holds like 90 right, and the top decile, most diversified hold like 500 stocks at that point. They're basically just an index on right at that point, then you really are just getting what's left over after the expense ratio right? And so, I think the problem is, when you look at all the trillions of dollars in assets out there in mutual funds, and you try to measure them all on an equal footing, then you get those results that say, hey, none of these people can beat the market. But if you go back to, you know, Buffett wrote an article called The Super investors of Graham and Doddville for, I believe Forbes. It's either Forbes or Fortune many, many years ago. And he makes the argument for active management, even though he sort of changed his mind later. And I think he changed his mind later because people weren't doing the things anymore the way that, you know, the students of Graham were doing them directly. But he lists, you know, several investors who he's like, I know that these people are going to beat the market over a long period of time. Walter Schloss was one, and there's a couple of others in there. And so in Buffett's youth, he was sort of on the same page as us, but as he got to a larger size and got a larger audience, I think the advice to a room of 10,000 people is, you know, most of you are probably going to lose money, right? So giving advice to an entire crowd versus giving advice to an individual is probably, you know, it's very different, right?

Well, and you know, Warren always used to make the comment about the average person is better off, right, right, followed by, whether it's buying S&P 500 index fund or what have you. And we've talked previously about sort of the fallacy of average right, right? Yeah. And you know, one thing that I always think back to is when you think about who the average investor is, if you take just the American population, right? 330 million people. And you think about, well, what's the average investor? Right? What's the average retiree? The average retiree is somewhere, you know, stepping away from work between 65 and 70 years old. They've got less than $100,000 to their name, right, a net worth of zero, right? And you compare that to a person who's got a, you know, half a million or a million dollars in a portfolio. And if they're trying to look at, well, the average person should, well, that person's not average, right, right? By definition, yeah.

I mean, none of us are average, right? I mean, that's the old thing about, you know, the plane wrecks in World War Two were caused because they designed the cockpit for the average pilot. And what they found by studying 1000’s of men is that no one is actually average. So, when you take the 13 or whatever it was criteria that they used to, you know, design a cockpit by the time they got down to the last person, no one fit all of the criteria right. And that's where we got things like adjustable seats and rear-view mirrors on our automobiles, right? Because we figured out that, you know. Know you have to, you have to adjust the plane for the pilot, not the pilot for the plane.

You made mention in your comments a minute ago about the average actively managed mutual fund out there having 90 holdings, and right, and a number of them, particularly from some of the bigger brands that are out there pushing 250, 300, 400 holdings. Sometimes, one thing about your investment portfolios from a fund selection is a lot of times the funds are ones that people have never heard of. 

Oh, sure, because they're small and, you know, a lot of times the fund company only has one or two funds, and the manager’s money is in there with ours, you know, that's something that's kind of important to me. And, you know, we try to get them on the way up. But now we've been using the same core group of mutual funds since probably 2012, 2013. And so now we've got, we're to the point where we have 10 years with them, and they've done well. So, a lot of them are bigger now than they were when we first started buying them, right? 

Buffett talked about the curse of being too big, yeah, right. And you kind of touched on that briefly, you know, maybe expand on that a little bit, you know. Because I think people would probably think, well, if you're bigger, you get economies of scale, and so you can do it cheaper, right, right? And so your expense ratio would be lower. So why not go with the big guys who are cheap? And the reason is because your opportunity set declines greatly. It gets to the point where you can't get enough money into a smaller stock in order to make a difference. So, you know, if you're limited to the S&P500, then it's going to be difficult to beat the S&P500, right, right? So, and it just gets, you know, at a certain point you've got enough revenue coming in where you're on the golf course, instead of, you know, behind the computer, right? 

Yeah. So, as you've mentioned that you worked with kind of the same funds by and large, for a long time, it's been a couple rotations, but the core group has been the same, right? So as you're evaluating funds, both those that have been in there for a long time, you know, knowing that, all right, we're not necessarily focused on getting the cheapest ones, right, right? We're looking for the ones that have a history, a track record, of, you know, performance that justifies the cost, right?

And a meaningful philosophy that, you know, we can understand. We don't want to have, we don't want all of our funds to be invested the same way. You know, some of them are deep value. Some of them are growth at a reasonable price. Some of them will hold cash when stocks are expensive. You know, we have one that actually decides based on committee, right? So, using all these different strategies causes the funds to be less correlated to each other.

So, as you're you know, moving forward, what are the criteria that you're using to evaluate whether it's a fund that stays in the portfolio mix and holds that spot? You know, you talked about viewing it not as a fund selection, but really as hiring, right? You know, really, you're hiring a team, right? You're hiring a person. So, you know, I think, you know, in a lot of our industry, there's a tendency of whatever wholesaler walks through the door, and, you know, I saw a lot of that in my younger years. Whatever the latest, greatest thing you know was all of a sudden those funds would start showing up in client portfolios, you know, what? What are the driving criteria that you're looking at, both for the funds that are there, in terms of maintaining their place on the payroll, if you will? But then also, what are the things you're looking at, as far as maybe new fund opportunities that might work their way in in the future?

So the thing that'll get you fired the fastest is if you change philosophy, because you know, because you're getting short-term bad results, right? And most of our managers are pretty convicted in their strategy, so we don't get much of that. As far as new funds are concerned, if I feel like there's a viable strategy that we don't have exposure to, then I'll start to try to interview them and see where they fit into the portfolio. 

And are you doing that proactively? Yeah, so that when an opportunity opens up, you've kind of already got a selection of folks you want to go back. So there's 25 asset classes that I have fund selections for, and we're only using like half of them, okay? So, if I ever want to add high-yield bonds, I've got a fund on deck. Now. I'll go back in and check and make sure that it's still, you know, the one I want to use. But you know, for basically every conceivable asset class, I have a fund selected that we would use if we wanted to add that asset class to the portfolio. Right? 
 
And are all of them active, or would there be, would there ever be a point in time where you would consider putting in a low-cost index component? 
 
Yeah, if the S & P had a P/E ratio of eight tomorrow, I'd probably use the S & P, but it doesn't so right? You know, the best time to buy the S & P was 1982 and everyone's using history since 1982 to tell you what a great. That's what it is, right? Well, but if you look at 1982 to 2009 it didn't look as good, right? So whenever you're sort of at the end of a big increase, it looks like that one thing, right? You know, is the best thing to do, right?

So, you know, obviously, you know, you've been doing this a long time, 25 years. 25 years. Track record is pretty good. So far, so far, hopefully continued. But I think the thing that's fascinating about you know, sort of your portfolio mindset here is there's no one overriding sort of rule or criteria aside from discipline, right? Commitment.

The problem with formula based or rules-based processes is that they're inherently quantitative, and unfortunately, we live in a world where qualitative data is really important, right? So, some of those things you just have to get your eyes on, and you have to make a determination of whether or not you know, it's the right thing for you, right, right? And costs are part of that, you know. Kind of go back to question. Costs are part of it. But, you know, at the end of the day, you could maybe get something for half a percent cheaper investment cost, but if it's performing one and a half percent less than the cheap thing,

I mean, you need to look at the net returns, not just at the expense ratio. But it is a factor. I mean, we use institutional funds. So, you know, our clients get the cheapest fund available at the fund family, they have significantly more expensive funds that some brokers would use to get, you know, because their compensation is tied to the fund. But you know, all of our funds are institutional if there's one available. So you know, we save 25 to 30 basis points, right there. Our turnover is low, so the trading costs are low. You know, inside the fund, that sort of helps keep costs down too, right?

Well, I think it's been interesting, right? I mean, that's a question. I think as advisors, we get a lot, you know, why do you use the funds you use? You know, performance is one component of it. Obviously, they've got a good track record. Track record and do what they're supposed to do when they're supposed to do it, but it's sort of inevitable. People want to know, well, why am I paying x instead of y?

So if you look at it this way, you know, if you pay 30 basis points or .30% of a fund with $100,000 in it, it costs you $300 a year, right? If that $300 a year is buying you 13 analysts, then that seems like a good deal, right, right? The larger we get, the more we'll manage the money in-house, but we can't manage money unless we have the staff to do it. Now, paying an extra 30 basis points to hire a team of analysts is cheaper for us and for our clients than it is to try to hire 13 analysts here, right? Just to manage the large cap portion,  right? So if you think about how many different asset classes we have exposure to, and I'd have to run a team of 200 analysts, well, that costs a lot of money. So, I think dollar for dollar, our clients are getting a good deal based on, you know, the total assets that we're managing here. And then you also get into some esoteric type asset classes where it would never really be in our best interest to have someone on staff, right? Because we don't use them all the time, right? You know, I could have the world's best preferred stock analyst, but, you know, I'm only using preferred stocks 15 or 20% of the time. What's he doing the other 80% of the time, you know? Yeah. So, I mean, a lot of these managers are really passionate about what they do. You know, you mentioned muni bonds, and their eyes light up, right? You know, those are the kind of people we want managing our portfolios. You just can't have them sitting around the closet waiting for the opportunity to meet them.

Exactly, right? So I'd say that's the number one factor for me when I'm picking a manager is how passionate they are about what they're what they're managing. You know, if real estate is your whole life, and I want you managing my real estate fund, right? And it's the same with equities. And you can tell by what they write and what they say on their conference calls, how attached they are to this kind of stuff. And that's a big qualitative factor that I can't put into mathematics. I can't put that in a formula, and you can't sort in a Morningstar database and see who the most passionate manager is, but it's something because of our size. We can get time with them and interview them and tour their facilities and talk to the staff and talk to the manager and find out, you know, how big of a part of your life this is. You know what you do, right? And that's what gets that's what causes us to hire them. It has nothing to do with the last three years' performance, right? Yeah, well, if you just make good decisions over and over and over, that's right, performance will follow, right? That's right. That's the idea. So cool. 

Well, I think this is, it's a fascinating topic. I think it's good for us to periodically get these kinds of questions where we can talk not just big, broad issues, but talk specifically about how you're making decisions, right? You know, sort of why we do the things we do, and why we do them the way we do them.

Yeah. I mean, I think it's difficult, because people have so much conviction about things like lowering costs and, you know. Of indexing, and they're not doing it from a position of evidence. They're doing it from a position of it's because it's what other smart people have said, Right? There was a time when smart people said the Earth was flat, and they were wrong. So we have to be really careful about who we believe without evidence, and just reading some study from 1985, it's not going to tell you, you know, all the nuances that go into hiring a mutual fund, right? And I just think most people don't put enough time into it,

yeah. And like you said, there's a little bit of selection bias in terms of the benchmarking.

Exactly, yeah. I've got a team of three people, four people, including myself, working on this stuff, 50 or 60 hours a week, right? So, you know, to the average person that wants to sit down and pick their mutual funds on a Saturday morning, you know, we have significantly more hours going into the process, right?

Cool. Well, I think that's kind of a good place to sort of wrap this. Finally. Had a short one. We had a short one. Yeah, people appreciate that. Yeah. Don't have to listen to us ramble for 45 minutes about some big, broad topic. So, no fascinating and we really appreciate the question coming in. You know, we enjoy doing this, hearing from people, you know what they're interested in, curious about. So with that, we'll kind of draw this one to a close again. If you've got a question, or hearing something in the news or reading about it online, or talking with friends and just wondering what's happening, send a question in who knows? Maybe we'll we'll chat about it. Alright, future episodes until next time. Appreciate you joining us here on The Point, and take care. Have a beautiful summer. 

Thank you for joining us for this episode of The Point Podcast, sponsored by Basepoint Wealth, as always, you can submit questions or topics you'd like to hear discussed to info@basepointwealth.com be sure to subscribe so you don't miss any future episodes. Basepoint Wealth LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.