The problems investors typically associate with mutual funds have less to do with the mutual fund structure itself and more to do with how the funds are managed.Nuthawut Somsuk/iStockPhoto / Getty Images
Many investors see ETFs as superior to mutual funds, and it’s not hard to see why.
Historically, buying mutual funds meant paying high fees for underperformance relative to benchmarks, along with underlying issues such as excessive portfolio turnover, style drift and closet indexing. It’s no wonder some clients ask their advisors why mutual funds should be included in their portfolio.
But before disregarding the category altogether, it’s important to keep in mind that the problems investors typically associate with mutual funds have less to do with the mutual fund structure itself and more to do with how the funds are managed. With the right investment approach, mutual funds can be a useful part of a client’s portfolio allocation strategy by improving tax efficiency and expected returns.
There’s a common perception that ETFs carry a structural tax advantage over mutual funds, but this simply isn’t true in Canada. Canada’s Income Tax Act includes the capital gains refund mechanism, which allows funds to recover capital gains taxes already paid when investors redeem their holdings.
Although both mutual funds and ETFs can use this mechanism, mutual funds often capture more of the benefit because ETF units sold on an exchange between investors don’t count toward the refund calculation, whereas mutual fund redemptions always do. Instead of being at a tax disadvantage, Canadian mutual funds are at least on equal footing with ETFs.
Better yet, when a mutual fund sticks to a low-turnover strategy backed by academic research, investing in mutual funds can be more tax efficient than buying ETFs. For example, Dimensional Fund Advisors’ Global 60EQ-40FI Portfolio mutual fund had only two capital gains distributions of less than 0.20 per cent from its inception in 2011 through 2024.
On the other hand, the comparable Vanguard Balanced ETF Portfolio (VBAL-T) showed capital gains distributions almost every year from its inception in 2018 through 2024, with some years exceeding 1 per cent.
Compounded over time, this difference in tax efficiency can lead to significant differences in clients’ after-tax returns.
While broad-market passive ETFs have played a pivotal role in lowering costs for investors, in recent years there’s been a proliferation of ETFs that charge higher fees for underperformance. Thematic ETFs are an example of this trend.
According to Morningstar’s Global Thematic Fund Landscape 2025 report, the long-term performance of thematic ETFs in Canada has been disappointing, with every fund that has existed for at least 10 years either underperforming global equities (using the Morningstar Global TME Index as a proxy) or closing.
As the ETF market becomes more saturated, advisors and investors need to be careful in distinguishing ETFs that truly outperform from those that don’t add value.
Meanwhile, the mutual fund industry has been closing the fee gap with ETFs in recent years, and it’s possible to find mutual funds that charge lower fees than their ETF category peers.
Some mutual funds also follow an evidence-based investing approach grounded in more than 100 years of market data and decades of academic research that examines how factors such as company size, value and profitability affect returns. By taking a more rigorous, scientific approach, some of these mutual funds have historically outperformed their ETF counterparts.
When comparing mutual funds to ETFs with clients, advisors should have the data in front of them and illustrate, through specific fund examples, why comparisons should be based on a fund’s underlying strategy rather than its structure. It also helps broaden the conversation to the role each fund plays in a client’s overall financial plan.
To build trust with clients, advisors should be prepared to clarify misconceptions and show which factors truly matter in building a portfolio that will meet their financial goals.
Tim Pritchard is a senior portfolio manager and senior wealth advisor with the Pritchard Wealth Management Group at Richardson Wealth Ltd. in Toronto.