Choosing From the Wide Variety in ETFs and Mutual Funds

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Remember when ice cream was simple, with a choice of vanilla, chocolate, and perhaps strawberry? No more. With specialty ice cream shops offering 101 flavors and then some, not to mention multidimensional cones, liquid nitrogen frozen hot chocolate, and powdered whipped cream, ice cream lovers are overcome with brain freeze even before tasting the first scoop.

Similarly, for investors, the rapid proliferation of exchange-traded fund (ETF) styles and multitude of mutual fund choices have made it difficult to understand the differences. But as Rich Powers, head of ETF Product Management in Vanguard Portfolio Review Department suggested, choosing between ETFs and mutual funds isn't that different from choosing between Rocky Road and Maple Bacon Breakfast.

"It boils down to what you're looking for, how much flexibility you need, accessibility to options, and total cost," said Powers.

What are you hungry for?

Many investors start with the decision to invest in an ETF or mutual fund before deciding on an investment strategy.

"Instead, we believe a good starting point is focusing on your investment objective," suggested Powers.

Are you looking for a classic plain vanilla investment strategy? You'll find broad index strategies available in both ETFs and mutual funds. But if you're searching for a style mash-up, such as caramel vanilla sea salt, or chocolate peanut butter cookie dough, you'll find them more often in mutual fund offerings than ETFs. While some actively managed strategies are available in ETFs—primarily rules-based strategies—a much wider variety of actively managed strategies are available through mutual funds.

For here or to go?

Beyond determining whether you want an active or index strategy, consider how much flexibility you want for trading purposes and how long you plan to hold the investment.

While mutual funds can be traded once a day—at the end of the trading day—ETFs offer the flexibility to be traded throughout the day when the market is open. Investors who value this trading flexibility, and who want greater control over the price and timing of trades, may find ETFs more appealing than mutual funds.

Powers added, "ETFs don't have restrictions on frequent trading like most mutual funds. If you're planning on investing for a short period, perhaps for tax-loss harvesting reasons, ETFs may be the best choice."

Like a cup or cone, both ETFs and mutual funds are vessels that can carry the same ice cream. Don't limit yourself to one or the other, because after all is said and done, you may find that you're better off with the container you didn't originally consider.

What's available?

Depending on which brokerage account platform you're using, your options for purchasing a particular mutual fund can vary, and sometimes widely. In contrast, because ETFs trade on exchanges, just like stocks, they're more accessible. If you have a brokerage account, you can buy or sell virtually any ETF.

However, similar to choices at an ice cream shop or grocery store that makes local deliveries, your choices are limited to what's available on the store shelf. You might find more options online, but both come with trade-offs.

Are the toppings included or extra?

The price of one or two toppings may be built in, whereas other ice cream shops charge by total weight or number of toppings. Either way, know your budget before you order so you won't be surprised by the total.

With a mutual fund, trading costs are effectively embedded in the net asset value (NAV), your purchase price. That's not the case with ETFs. You may find an ETF with a low expense ratio, but if wide bid-ask spreads* make it more expensive to trade, you’ll pay more for the "toppings." When you're choosing between a mutual fund and an ETF, focus on the "all in" expense.

One of each, please!

"Whether your next investment move is with an ETF or a mutual fund, Vanguard offers both, and we believe both can serve a purpose in your investment plan," said Powers.

Because ETFs and mutual funds are more similar than different, focusing on your investment objectives, flexibility needs, and the cost differential can help you make an educated decision.

* Bid-ask spreads are the difference between the price a buyer is willing to pay (bid) for a security and the price that a seller is willing to sell their shares (ask). The wider the spread, the higher the implied cost is of buying ETF shares. For sellers, the wider a bid-ask spread is, the lower the price is when you sell shares.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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