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.
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.
Well TBO there are advantages for both. An ETF is just like a stock and you have to buy and sell like a no-life day trader. And no you don't need a fund manager. You can open a Vanguard or Fidelity account and manage your own mutual fund portfolio.. Have it auto invest in various funds YOU pick directly from your bank account, and invest into your picked funds. PASSIVE INVESTMENT is the name of the game here! Or you could blow ur brains off buying selling all day and dreaming of numbers. Oh and did I mention the Dividends reinvestinto your funds AUTOMATICALLY.. -JS
I truly don't understand how people can keep investing in mutual funds. Didn't millions of people lose billions of dollars back in '07-'08?
At least with an ETF, you can get in and out without penalties. A lot of discount brokers are now even offering free ETF trades to their clients.
If you want someone else to control your money, then pick a mutual fund but if you want to maintain even the slightest say in what your investments are doing, learn a little yourself, and trade yourself. Sad to say it but the days of stock brokers are rapidly coming to an end. Especially on a GenX blog, I'm sure a lot of us enjoy being involved in the trading process as opposed to just dumping funds into an account your advisor or broker recommends.
Good overview Jeremy. I've got an account with Vanguard and they have really low expenses on mutual funds. I'm going to have to take another look at ETFs though.
Nice overview. I haven't really seen the pros and cons laid out like this before. I will be investing in either ETFs or Mutual Funds outside of my retirement accounts very soon so learning about them both is necessary. Thanks for the details!
Very nice post. This gives all the considerations an investor needs to make the right choice. Very well done.
This is a great post Jeremy - you've done an awesome job of explaining the differences as well as the pros and cons!
I guess everyone has a preference to invest according to one’s need, resources available, financial goal and various other factors. Investing in ETFs or mutual funds has to be after scrutinizing the pros and cons of both, researching and analyzing the company’s turnover and performance.
You can get around ETF trading costs by having a Vanguard or Schwab account. They offer very low expense ETFs which I would buy anyway even if the transaction cost wasn't 0. I've just recently changed all my holdings out of mutual funds into ETFs - and lowered my average expense ratio from 0.8 to 0.17.
I've dabbled in mutual funds and so far, I like them. They're fairly safe (as long as I do my homework beforehand!) and since I purchase them through USAA, a few of them waive the large initial deposit as long as I commit to a monthly debit. ETF's are still new to me, so thanks for the information.
It seems to me that the stock market and the regular market (Wall Street as opposed to Main Street) is a shadow economy. How can the stock market be seeing record profits when the real ecomony is still in the tank, companies are still laying off people, and people are still without jobs? The answer I think, in part, is that the reason these companies are hitting record stock prices is precisely because they are laying off people and downsizing. They are saving a lot of money instead of making money, which they pour into their stock prices (hence the market is inflated) or that is to say, they are making money by doing these things rather than truly attracting new customers.
I have to echo a few of the comments here. Great piece. I like ETFs especially if I can find a brokerage firm that offers zero trading costs. Then I get the lower expense ratio AND no trading costs. Cha-ching!
Currently I have invested money only Mutual Fund, I have planned to invest money with low risk that’s reasons I am preferable mutual Fund. Thanks for sharing ETFs fund information with details definitely I will plan to invest ETFs as well.
I think the key to that is to go make sure that you are properly informed. What you need to do is to fully understand how both funds work to know which one best suits your strategy for investing. It will make a whole lot of difference.
I like Exchange Traded Fund more. "An ETF holds a collection of securities that are designed to track the performance of an index"
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I prefer the freedom of trading the ETF. With mutual funds I feel I can only get one price and that is at the end of the day. I can day trade an ETF like UNG or I can hold it. My money is on ETFs
Wow... I've got to tell you... this had to be one of the most comprehensive articles on ETFs vs. mutual funds that I have ever seen that actually makes sense!
Love you writing. Thanks for the info.
to those mentioning trading fees regarding ETFs... just sign up with a brokerage like zecco where you get 10 free trades a month and that eliminates that problem.
ETFs are a solid way to go most of the time.
After tax returns and fees are the two things you need to look out for in most investments. ETF's should always be the preferred choice becuase 75% of funds do not beat the market - so why pay more for them. Great post for reference.
I'm really late with this, but I wanted to say this is one of the best pro/cons of ETFs I have read. Thanks for the great post!
If you're going to invest in an ETF that tracks an index, just buy the index fund.ETFs have their place (like individual stocks do), but if you're going to continuously invest in a fund, then do yourself a favor and stay away from them.
I personally prefer ETF's because the trading fee is a fixed, up-front cost while higher expense ratios will continue to eat into your profits everyday you own the mutual fund.
Great post. We are big fans of ETF's, primarily to trade commodities (referred to as ETCs). Our trading system has a huge range of ETFs and we find them particularly easy to trade... you are right to ask the question 'are they for you' asthey will suit a certain type of investor but not others.
I invite anyone interested to download the demo system at HF Markets
where you can see a range of ETFs and how they trade.
The one thing that's been keeping me away from ETF's are the trading fees. Even though ETF's have lower expense ratios than index funds, the trading fees end up costing more than the higher expense ratios.
Awesome post Jeremy. I've been hearing about ETFs a lot and I didn't really know the differences between them and index funds. I just thought it was a more niched index fund. I gotta catch up on all the posts around here, good stuff as usual!
Great post - love the detailed pro and con lists. This is the kind of stuff that is really helpful to newer investors (like me).
So far I've only invested in mutual funds because of the brokerage account requirement - maybe one of my financial goals for 2009 will be to give ETFs a try.