Investors are always looking for ways to diversify their portfolio. To do this, they often look to various types of funds that can provide this diversification without having to buy individual securities. Mutual funds or exchange traded funds (ETFs) are two of your options.
Before we get into a discussion comparing and contrasting mutual funds versus ETFs, let’s first get on the same page defining each one.
What are Mutual Funds?
Most people are familiar with mutual funds, as many have been exposed to them via their 401(k) plans. As its name implies, a mutual fund is a large portfolio of investments that are mutually owned by all of the shareholders. Each investor owns shares. These funds are also professionally managed. These investment professionals select a mix of stocks, bonds, money market accounts and other options for the mutual fund and make buy-sell decisions on behalf of the shareholders.
What are Exchange Traded Funds?
Like mutual funds, investors get an opportunity to pool their money to invest in a variety of companies. Unlike mutual funds, ETFs are passively managed investments that are traded on a stock market exchange.
ETFs are designed to track indexes. What does that mean? As an example, let’s take the S&P 500 where you have 500 companies. The ETF of the S&P 500 index will own all of the different pieces of the shares inside the index. It’s much less expensive to track an index than it is to research individual stocks to buy and sell.
Note: This is the traditional ETF and still exists today. However, a growing number of ETFs also offer active strategies but come at a higher cost.
Comparing ETFs vs Mutual Funds
First, there are some similarities between mutual funds and ETFs:
- Less risky than investing in individual stocks and bonds
- Wide range of investment options
- Managed by professional investment managers
But there are differences to consider as well.
Due to their passive nature, ETFs have historically been less expensive to run compared with mutual funds. ETFs gained popularity over the years due to their low cost approach. If you look at historical statistics, the cost of owning mutual funds is much higher than ETFs. The increased cost for managing mutual funds is due to the expenses associated with all the individuals involved in managing mutual funds. In essence, mutual fund managers historically couldn’t make up the difference between what they were being paid and the returns on indexes.
Therefore, in the past, most experts would agree the ETF structure was better for most people. The mutual funds’ expense ratios were excessively high and the companies were making a lot of money. The higher costs of mutual funds were just too hard to justify. And at that point, ETFs were better.
So, the mutual fund companies had to scramble to become more cost competitive. As a result, today’s mutual funds have a lower cost structure than in years past. If you now ask an expert which is better, they’d have a harder time answering. But one piece of advice is certain. If you’re going to invest in mutual funds, make sure you generally stay away from higher priced mutual funds.
It’s also important to note that a growing number of ETFs also offer active strategies which come at a higher cost. So the line between mutual fund and ETFs seems to be getting more blurry.
Which is right for you?
The best way for you to decide if either of these options are right for you is to consider your goals, financial situation, risk tolerance and timeline in order to identify appropriate investment options. Because of the complexities of each, speaking with your financial adviser is always a good idea.
Consider investing in an ETF if you:
- Are an active trader and want flexibility
- Believe that passive management will provide better returns than active management
- Believe that a lower cost approach is superior
- Want better tax efficiency
The drawbacks of an ETF include
Consider investing in an actively managed mutual fund if you:
- Believe that active management will outperform passive management.
- Believe that paying higher fees will result in even higher performance.
- Are not an active trader
And as always, if you have any questions, contact an expert who can help guide you to make the right decisions based on your personal situation.
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