Investment decisions are filled with many ongoing, never ending debates: stocks vs bonds; IRA vs Roth IRA; active vs passive, 4% vs 3.3% rule?
While it is pretty easy to determine a winner in some of these face-offs, one of the hardest to decipher is exchange-traded fund (ETF) vs mutual fund. Their similarities make them nearly identical to the average investor, while their minute differences might appear as light and day to a seasoned financial planner.
Deciding on which one is the better investment for you will depend on a number of factors. But first, let us look closely as to the similarities and differences for them.
What are the similarities between ETFs and Mutual Funds?
- They are professionally managed collections of stocks or bonds
The first major similarity is their structure. Both ETFs and mutual funds are a basket or collection of stocks and bonds. They provide a near perfect alternative for investors who don’t want to pick or rely solely on individual stocks or bonds.
Yes, you theoretically could handpick several stocks and bonds you could come up with a decent diverse portfolio. However, that would require you to literally pick hundreds of separate individual stocks, whereas with a mutual fund or ETF you get those hundreds of stocks just by owning one fund.
In addition, these funds are professionally managed, so you don’t have to do all the research and maintenance on your end, and can instead delegate it to a professional.
- They are less risky than buying individual stocks and bonds
The key to minimizing investment risk is diversification. ETFs and mutual funds are by nature very diversified. Each one may invest in hundreds or even thousands of different stocks and bonds, thus lowering your chances of owning a string of losers.
- They can either be actively or passively managed
There is a common misconception that mutual funds are actively managed while ETFs are passively managed. While there are in fact a lot of actively managed mutual funds, there are also a lot of passively managed ones.
The same is true of ETFs, in that you can also find actively managed options.
- You don’t have to pay a commission on either
Again, this is another area rife with untruths. ETFs rarely have a commission, but there are also commission-free mutual funds. If this is what you are after, you can easily find good options for both funds.
- They provide multiple investment options
There are so many different ways to invest with both funds. You can invest solely in U.S. stocks, solely in international funds, or a mix of both options too. You can also choose to focus on particular sectors or have a blend that encompasses nearly everything under the sun.
What are the differences between ETFs and Mutual Funds?
- Minimum investment
Whether you can invest in an ETF or a mutual fund can depend on how much money you have. On average, you need more money to invest in a mutual fund, as the starting investment may cost a few thousand dollars.
Since ETFs are traded like shares, you can buy one for as little as $50, and this can go to as high as a few hundred dollars. Therefore, if you don’t have up to $3,000, you might want to focus on ETFs.
- Tax efficiency
As mutual funds tend to be more actively managed, there is a lot of internal trading. When gains are realized on those trades, it trickles down to the investor, thus making them less tax efficient.
On the other hand, ETFs don’t have as many internal trades, and instead use a creating and redemption mechanism to correct the price. Few internal trades mean fewer taxable events, so they are more tax efficient. In fact, in some cases you can go a long time without paying capital gains tax on your ETF, only until you decide to sell.
- Automation
If you have a structured investing pattern, like buying shares every 2 weeks or every month, you can set up an automatic instruction to purchase (or sell) your mutual fund on that schedule. This is probably my favorite feature of mutual funds, because it makes it easy to set up good decisions, automate it, and then not have to worry about the trades every 2 weeks.
Unfortunately, you don’t have that option with ETFs.
- Trading frequency
Mutual funds are traded only once a day, at the close of business, while ETFs can be traded at any time. This gives investors more control over the price of ETFs, as they can use more order types and offer real-time pricing.
- Expense Ratios (Fees)
Even though you can invest in both types without paying an up front commission, there are ongoing costs you will incur for the management and maintenance of the fund. So there will be fees for each of them, and typically the average mutual fund fee is more expensive than the average ETF.
According to Vanguard, the average ETF fee is 0.24%. And according to Morningstar, the average fee for index mutual funds was .73%, while actively traded mutual funds averaged 1.45%.
When Should You Choose ETFs?
Now that we have covered their differences, we can make some quick assessments as to when you should choose an ETF over mutual funds. The two most common instances when this happens are for:
- You have a lump sum of money you want to invest, but don’t plan to make ongoing contributions often, or you don’t mind placing the trades
- Brokerage account-holders – given the tax efficiency of ETFs, it is better to hold them in a brokerage account (a taxable, non retirement account) than in a retirement account
When should you choose Mutual Funds?
On the flip side, mutual funds are great if:
- You have regular investing patterns – for example, you want to invest $1,000 each month directly from your paycheck, and you don’t want to place the trades on a regular basis. This is the best reason in my mind to choose a mutual fund.
- If you’re trying to beat the market – it is a lot easier to find an actively managed mutual fund (again, I wouldn’t recommend trying to do this!)
- If you’re interested in niche markets – niche markets often tend to be less-efficient, and harder to get into, so an actively managed mutual fund might be the best option.
Final Verdict
As you can see whether an ETF or a mutual fund is better depends on your personal circumstances like your investment amount, how often you plan to contribute, how you want the fund to be managed, etc.
If you’re interested in my opinion, I think the best way to go is a low cost, well diversified investment portfolio, which you can get with both ETFs and mutual funds.
The biggest question in my mind is whether you’ll be making ongoing contributions. If so, then the ease with which you can do that with mutual funds is great. But if you don’t know if you’ll contribute on an ongoing basis, or if you don’t mind going in and placing trades, then I’d probably recommend ETFs.
If you would like to me to review your investments and see if your portfolio is property structured for your retirement, go to startmyretirement.us and we will get to work on creating a one-page retirement and investment plan for you.