The Duel: ETFs vs. Mutual Funds

by Robin Applegarth on 7 September 2010 3 comments

Which is the better investment? Both Exchange Traded Funds (ETFs) and mutual funds offer diversification and low-cost options. Knowing how they work can help you decide which is best for your needs. Let's have them face off, and see how each performs.

ETFs

ETFs are formed of large batches of stocks or bonds, called Creation Units, and held by institutions. Individual investors can buy shares of these units.

ETF Advantages

  1. Sold throughout the trading day like stocks, so you can pick your buy and sell price with limit orders. Has the flexibility of using options, stop losses, and other trading techniques.
     
  2. Lowest costs over the long term, if you select a low-fee ETF, low-fee brokerage, and don't make many trades. ETFs don't hit you with extra fees such as early redemption, minimum balance, etc.
     
  3. You can buy as little as one share of an ETF, compared to mutual fund minimums of usually $1,000 or more to open an account.
     
  4. Less tax consequences when large numbers of investors want to sell. (Mutual funds are forced to sell shares to raise cash for redemptions.)

ETF Disadvantages

You'll need to keep reinvesting your capital gains and dividends by buying new batches, as they don't automatically do so. And, watch out for small or new ETFs, which may be "thinly traded" and hard to sell. ETFs can only be sold when there is a willing buyer on the other side of the trade.

ETFs and Index mutual funds share the following traits. Both are tied to a benchmark, or index, so don't expect them to outperform that index. You'll need to buy several types to get proper diversification. There is no human at the helm, so if the index is headed downhill fast, no one will switch into a defensive position.

Mutual Funds

A mutual fund is a collection of stocks, bonds, and/or cash investments that are packaged together, like a suitcase of clothes. They can be "closed-end" or "open-end."

Closed-end funds are like a suitcase that gets packed once, locked, and stays in the closet.

Most mutual funds are open-end. Their contents get unpacked and changed over time. It's like a frequent traveler who likes to buy new clothes and sell old ones along the trip.

Open-end mutual funds can be actively managed, or passive, index funds.

Actively managed mutual funds are run by managers who pick what they want to put in their suitcase, or portfolio. These have higher fees because management has to work at figuring out what and when to buy and sell. Some people prefer to keep part of their investments under professional care.

Unfortunately, professional management doesn't guarantee better results, with only about 20% beating the averages. Choose carefully, looking for good 5-10 year performance, and goals that match your needs.

Passive, index mutual funds match a pre-determined benchmark, such as the Standard and Poor 500 or Russell 2000. Index mutual fund holdings may get adjusted over time, as these benchmarks change.

Fees

If you need a broker or adviser to help choose your fund investment "wardrobe," be prepared to pay more. You'll be charged a 1%-5% "load."

No-load mutual funds don't charge a sales commission, and there are thousands of them available. They're great for do-it-yourself investors who know a little about what they want.

Speaking of fees, all funds (load, no-load, and ETFs) have annual management fees, or "expense ratios." Expense ratios usually cost 0.2% to 1.5% per year.

ETFs and Index funds generally have the lowest fees, as they are managed mostly by computer. Compare fund costs with the free fund analyzer tool from the Financial Industry Regulatory Authority (FINRA).

Mutual fund advantages

  1. Larger selection of investment choices (although ETFs are catching up). You can find a number of diversified mutual funds that hold stocks, bonds, and cash, so one fund is all you need to start.
     
  2. The opportunity to get active, professional management, which might beat the market averages.
     
  3. Easy automatic reinvestment of dividends and capital gains. No need to make additional purchases to keep all your money invested, as with ETFs.
     
  4. If you can meet the minimum buy-in, these are well-suited for dollar-cost-averaging, or frequent small purchases.

There is no "one size fits all" investment, so put away the dueling pistols. The main thing is, pick investments geared to your needs, and get started.

What do you like best about ETFs or mutual funds?

This is a guest post by Robin Applegarth. Robin started The Silver Purse in September 2009. An investor with over 20 years’ experience, she hopes to inspire women to get "money literate" and build the resources to reach their goals. Read more by Robin:

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Nick

I love ETFs but they are fairly new, so there are some managment firms who are still getting their feet wet. But, sticking with the big boys, I prefer ETFs. My discount broker has its own dividend reinvestment program (that's free - including commission free for the reinvestments), which I'm signed up for, so your discount broker may have a "workaround" for the reinvestment issue.

Guest's picture
Dangerman

"You'll need to keep reinvesting your capital gains and dividends by buying new batches, as they don't automatically do so. "

This is WRONG.

All the major brokerage houses (Vanguard, Fidelity, Schwab, eTrade, etc.) all automatic reinvestment of ETF dividends. It's a "market" order, and you can get hit with trading fees if the ETF isn't that brokerage's own (i.e. Vanguard give no-fee purchases of Vanguard brand ETFs, Schwab of Schwab's ETFs...). So if you stay within one ETF family, the reinvestment options really aren't a reason to not use ETFs.

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Robin

You're correct that a growing number of brokerages allow you to reinvest dividends of ETFs--if there are any.

It's a different process than w/ mutual funds tho. Vanguard says you can set up that request in the default setting for your brokerage acct. Schwab adds that it can be done during the purchase order. Thanks for the clarification.