Many investors are wondering, “Should I purchase a mutual fund or an exchange traded fund?” That is a valid question because there are some pros and cons for both sides. Mutual funds have been around much longer and offer investors stable returns, usually. As many 401k holders know, mutual funds can decline in value. Exchange Traded funds offer the flexibility of a stock with the diversification of a mutual fund. But which one is better? Of course, your specific situation will require the help of a financial advisor but here are some of the benefits of mutual funds versus the benefits of exchange traded funds and the cons of each. Let’s see how they stack up in this week’s
Mutual Funds versus Exchange Traded Funds
BATTLE ROYALE!
Let’s get ready to rrrrrrrrrrrrrrrrrrrumble!
Basket of Stocks
Both mutual funds and exchange traded funds offer diversification by compiling a basket of stocks or other assets. Mutual funds allow the fund manager to choose the basket of stocks. Essentially when you purchase a mutual fund, you are putting your trust in the fund manager to be a good stock picker. They will need to be fairly good at researching a stock and buying at a reasonable price. With an ETF, the stocks are chosen based on the index it attempts to track. An ETF should be more closely benchmarked to an index and track its gains and losses accordingly. Instead of attempting to beat the index, the ETf attempts to track its performance closely. However, some ETFs are set up as 3X the index where if the index is up 1 point, the ETF would be up 3 points, but this type of leveraging also works in reverse and of the index is down 1 point the ETF would be down 3 points.
Winner: Mutual Fund for its potential ability to beat the market.
Alternative Assets
Many investors are becoming more interested in alternative assets such as foreign exchange, real estate, commodities, and such. An ETF can hold commodities, stocks or bonds. After I did a screen on Morningstar for mutual funds based in commodities, I got zero hits. However, I did see some mutual funds once I reset the screen for Alternatives. I found mutual funds in categories such as managed futures, currencies, and precious metals. These mutual funds are comprised of commodities, foreign exchange and metals such as gold and silver.
Winner: Tie since both mutual funds and ETFs can invest in alternative assets.
Fees
In order to hire someone to invest for me, I would have to pay that person or firm a fee. Generally this fee is based on how much they make for me, but it could also be based on the amount of my investment.
Mutual fund managers charge various fees, with the typical fees being included in the expense ratio. The expense ratio is an annual fee charged by the mutual fund, it is calculated as a percentage of the assets invested and it typically includes administrative fees, management fees, legal fees, etc. In addition the mutual fund may charge a load fee to invest in the fund.
ETFs also have fees though they are generally significantly lower than those of mutual funds and they are included in the unit price. However, with an ETF you will have to pay your broker to trade in and out of the fund, while mutual funds have no transaction fees. However, if you do not trade often, you will not incur these fees.
Winner: ETF, for its minimal and simple fees
Minimum Investment
This one is pretty simple. With a mutual fund, the minimum investment is set by the management and it could be anywhere from 1k to 100k or more. For example, one of the managed futures strategies that I found had a minimum investment of 25 million! (Search Morningstar for RYYSX and look all the way to the right for Min. Inv.) But most funds that invest in stocks had a minimum investment of 2500 and some required a minimum investment of only 1000 dollars.
With an exchange traded fund the minimum investment is just the price of one unit. If the current price is $50.76 per unit then that is your minimum investment cost.
Winner: ETF for its benefits to the smaller investor
Stability
Mutual funds typically allow purchases and redemptions at the end of the trading day. There is no buying or selling a mutual fund through out the day.
ETFs are traded like a typical stock and can be bought or sold throughout the day. This potential for frequent trading can be a negative because speculation can cause the price to dramatically drop or rise within the course of the day. If you take a look at the historical prices of mutual funds, each day’s price (called net asset value or NAV) is generally within a few cents of the previous day’s NAV. This stability fooled some investors into thinking that mutual funds are safer than ETFs or individual stocks, but that is not true. If you owned mutual funds through the recession then you know this as well.
Winner: Mutual funds for reduced volatility and daily change.
Well it looks like we have a tie! Which brings me to my final point; either could be better for you depending on your situation. I’ve chosen to do a mix of the two. Which have you chosen?
I love your graphic! Did you do that yourself?
Although I don’t own any, I though a major advantage of Exchange Traded Funds was that you COULD sell them during the day – to take advantage of the volatility.
I am more of a buy and hold kind of person so that doesn’t really matter to me.
Thanks! Yes, I try as much as I can with the little graphic skills I have lol
Same here, even though I could buy and sell ETFs, with stocks in general I am a buy and hold investor.
Don’t they have different tax ramifications?
That’s a good question. I think that the gains are taxed differently but I’m not entirely sure.
Interesting comparison. I am solely invested in mutual funds at the moment, but my wife is solely invested in ETF’s. I think they both have their place, but I’ll stick to the mutual funds for now.
Looks like between the two of you guys, you are pretty diversified already!
I have both. My 401k only have MF so that’s what I had to go with. In my taxable account I have a few ETFs due to the lower cost.
Yeah, at my job we are only allowed mutual funds in the 401k but I buy a few ETFs in my personal account and Roth
I’ve been investing since 1988 (I know I’m an older guy) I started with term deposits then started buying mutual funds and then finally ETFs. 10 years later I sold all my mutual funds and ETFs. In my over 20 years of investing experience I’ve found that investing in quality stocks when they are undervalued is the best way to go. This style of investing is called value investing.
Value investing is not difficult or time consuming, and the younger you start the better off you will be. In my opinion forget about MF and ETF and buy stocks yourself, you will save thousands in fees and avoid the poor performing mutual funds. The majority of mutual funds under-perform the stock market anyway.
I am a big fan of value investing. I actually did a review of Morningstar, which is a good place to start research for value investing.
http://www.fsyaonline.com/how-to-use-morningstar/
For new investors that are willing to take the time to watch the markets then purchasing individual stocks might be their cup of tea. But even so, it’s always good to diversify. I regularly buy stocks for value or growth, but I throw some ETFs in along with it.
I love MFs and ETFs. They are great tools for investing with a diversified strategy made easy
Easy always works for me. Then I can spend my time on more important things
I have only MFs and I am proud of them , all of ‘em I think I should start looking in to ETFs you have given a nice kick to start it sooner
ETFs defintely deserve a look. Especially since they track an index they are a good way for quick diversification if you have an all stock portfolio.
Latisha, I own both as well. As long as you start investing NOW, either option is a good one!
Very true Barbara! Time is always the best asset you have.
I love posts like these fun and informative. Who doesn’t love a good old fashion match up?
Thanks Niki! I’ve got another one coming on the Yakezie site soon. Also I’m working on some more match ups to come
We did a similar comparison when opening ROTH IRAs for us last year. We ended up going with mutual funds (Vanguard) only because the fees were lower for the mutual funds. Usually the ETFs fees are lower, but with Vanguard if you cross a certain threshold the mutual fund’s fees get close or lower than the ETFs. Just an extra data point… Nice comparison.
So I’m guessing that with a larger investment the fees get lower? That would make sense. Do you know what the level is? That might make mutual funds more attractive to me.
Nice comparison LaTisha! I did a similar comparison with Vanguard ETFs and Mutual Funds and ETFs came on top!
Since I have commission-free trading, made more sense to go with ETFs
Wait a minute. Did I hear you right? How do you have commission free trading? I think a few brokers do it for select ETFs, but do you have it for everything you trade?
I have two ETFs (SPY & QQQ), mutual funds and a few stocks in my portfolio. I see no particular advantage for ETFs because I do not time the market. I rely on the fund managers to do that. The difference in fees is nominal because I chose mutual funds with very low expenses.
SPY and the Q’s seem popular. I have a friend that trades them frequently on economic news.
A few years ago while iN school and getting into investing, I chose some etf’s (SPY and QQQQ) I believe – I ended up selling those eventually, and now I’m investing with mutual funds. It was nothing against etfs, but the place where I invest now just has really good mutual funds.
Yeah, it seems like ETFs are typically left in favor of mutual funds. More than likely it is because they do attempt to beat the market.