ETFs and Mutual Funds Both Have Advantages – Find Out Which One is Best For You
Lately I’ve received a few questions from readers asking about the difference between an ETF and an index or mutual fund, and which one is better. Well, as with almost all things, there are pros and cons to each. There is no right answer that applies to everyone, but I’ll provide a little background information and examples of why one might be better than the other for certain reasons and situations.
ETF Basics
An ETF, or Exchange Traded Fund, is nothing more than an investment portfolio consisting of many investments that trade like stocks. An ETF holds a collection of securities that are designed to track the performance of an index. This means that if you purchase a share of an ETF that tracks the S&P 500, you should see daily changes in your share price that come very close to, or exactly mirror the actual performance of the S&P 500.
ETFs were introduced in 1992, and back then, there were only a couple offerings. Even as late as 1999, there were only 32 ETFs in existence here in the U.S. markets. The ETF market has grown considerably as there are now nearly 1,000 available. This is good news for investors who are looking for ways to invest in many specialized niches, but it is also bad news because it can make choosing the right ETF more difficult than it has to be.
Mutual and Index Fund Basics
To give you some perspective, mutual funds have been around for a very long time compared to ETFs. The first mutual fund was established in 1924, and they have served as the primary investment vehicle for the average investor for decades. Like their ETF counterpart, a mutual or index fund is simply a collection of investments that are designed to reflect the performance of the underlying holdings. Mutual funds may have widely varying portfolios may not track a specific index, whereas an index fund is designed to track the performance of an index.
One of the biggest differences between funds and ETFs are the way they are bought and sold. ETFs trade like stocks, so that means the price per share of an ETF changes continually throughout the day while the markets are open. This allows you to buy and sell an ETF multiple times a day if you wanted. On the other hand, mutual and index funds only trade once a day. Because of this, you might place an order at 10 am, but you will get the shares for whatever the closing price is at the end of the day.
The other difference is in the fee structure. Mutual funds can have a number of ways to charge the investor–from front-end loads, back-end loads, early redemption fees, and everything from management to advertising expenses. ETFs have a very straightforward and transparent expense ratio (although, some mutual and index funds do as well).
Advantages of ETFs
While there are many similarities between these products, there are some potential advantages to ETFs:
- Low Ownership Costs – Because of their efficient structure that tracks an index rather than pay investment managers to create a portfolio, the recurring expenses for most ETFs are very low.
- Tax Advantages – While this isn’t really a concern if you’re investing in a tax-deferred account, ETFs are generally very tax friendly. In many cases, you are in control of when you pay capital gains tax because you pay it when you sell your shares. You aren’t at the mercy of wondering whether your mutual fund is going to declare a capital gains distribution or not. Many ETFs have never issued a capital gain distribution, and even the ones that do generally minimize the impact significantly.
- Liquidity – As I mentioned above, ETFs trade throughout the day just like a stock. This means you can buy and sell multiple times a day if you want, or buy and sell with virtually immediate results. You can also place market, limit, and even stop-loss orders through your broker for ETFs.
- No Minimum Investment – With an ETF, you are only limited by the amount of money you have and the price per share. Many mutual funds require thousands of dollars as a minimum before you can even invest in a fund, so ETFs have a much lower barrier to entry.
- Options – Since ETFs trade like stocks, many popular ETFs also have corresponding options. For more sophisticated investors, this means you can buy puts and calls, create spreads, or other creative techniques to hedge your investment. You can also trade ETFs anywhere you can trade stocks, so a discount broker like TradeKing is an affordable option.
Drawbacks of ETFs
Even with so many advantages, there are also some drawbacks:
- Trading Costs – Since ETFs are traded like stocks, that means they generally have transaction costs like you would trading stock. Trading commissions can vary widely, from $0 to $20 or more per trade. These costs can eat into your returns.
- Brokerage Requirement – While most brokerages offer ETF trading availability, if you don’t currently have a brokerage account, that means you have to establish one. Brokerage accounts may also have account minimums or recurring fees, so you need to shop carefully.
- Slippage – This doesn’t really apply to someone buying an ETF with the idea of holding it for many years, but because ETFs trade like stocks on the open market, they have a bid and ask price. This means at any given time, what you can buy and sell a share for will be different.
- Dividend Drag – Unlike mutual funds, dividends paid out by the ETF are not reinvested which is common with mutual funds. This means the investor is paid the dividend in cash.
Advantages of Index/Mutual Funds
We’ve taken a look at the pros and cons of ETFs, so let’s now look at how index and mutual funds shine:
- No Trading Commissions – In most cases, you can invest in a no-load mutual fund without incurring a trading fee. While there may be a minimum initial investment, you can make purchases without being charged a trading commission as you would with buying/selling a stock or ETF.
- Dividend Reinvestment – Unlike ETFs, dividends paid out by the fund can be set to be automatically reinvested into the fund. This can be a significant benefit for funds that pay out regular and sizable dividends.
- Breakpoints and Share Classes – While I advocate no-load funds, the fact is that many investors do invest in funds that have loads, whether through a broker or otherwise. With different share classes from front-load, back-load, institutional shares, there is flexibility in how funds are purchased. There are also breakpoints on fees for having a certain amount invested with one particular fund company.
- No-Fuss Pricing – Since funds are price once at the end of each trading day, there are little surprises. With an ETF, the underlying share price may change minute to minute, and fluctuate a few percentage points throughout the day. While not a huge concern for the long-term investor, it can be a little unsettling to lose 1-2% on your trade mid-day trade due to market conditions out of your control.
Drawbacks of Index/Mutual Funds
ETFs and mutual funds have many things in common, but there are some drawbacks as well:
- Actively Managed Expenses – Not so much a concern for the index fund variety, but some actively managed funds may come with high expenses. These high expenses can really drag down your performance over time.
- High Minimums – Many funds require a high minimum investment just to get started. In some cases, this can be anywhere from $1,000 to $5,000 or more. This prohibits new investors without a lot of capital from getting started in the fund they may want.
- Additional Fees – Some funds have substantial front and back-end sales charges, and may even have 12b-1 fees to cover expenses such as advertising. While not all funds have these, some investors may inadvertently invest in funds with these fees without realizing it or by being tricked by a salesman.
- Style Drift – Funds that aren’t tied to a specific index are subject to the whims of the portfolio managers. This means they can alter and change the investment holdings in an attempt to bolster returns. This can be good, but more often than not, it means your investment is not doing what you wanted it to do when you purchased it.
What’s Right for You?
Hopefully the information above has shed some light on the pros and cons of both types of investment vehicles so that you can determine what would work best for you. There is no right or wrong answer, and there is no single product that fits all scenarios. In fact, there are many instances where it is desirable to have both ETFs and mutual funds in your overall portfolio. The tax advantaged ETFs will make more sense in a taxable account, and funds that regular issue capital gains distributions will be better suited for tax-deferred retirement accounts. And if you’re interested in short-term trading, ETFs are the way to go, but if you will be investing small amounts regularly, a mutual fund is going to help eliminate the trading costs associated with ETFs.
So, take a look at your situation and what you want to accomplish with your investments. There are a lot of choices out there, and it can be overwhelming, but it doesn’t have to be difficult. Take the time to understand how these investments work, and what the true costs associated with them are, and you’ll be on your way to maximizing your returns in no time.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
