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Choose ETFs Over Mutual Funds for Your Portfolio

Recently, I ran a Google search on the mutual fund vs. exchange-traded fund (ETF) debate and found a very interesting and, to me, baffling phenomenon. Most of the pieces I read bent over backwards to try to provide some form of balance, desperately trying to give equal column inches to the arguments of both sides, as if this was some kind of close-run thing with each side as worthy as the other.

While I am all for balance when it comes to writing about Democrat vs. Republican, New York Giants vs. Jets, Coke vs. Pepsi or even carnivores vs. vegans, there surely comes a point where—faced with one side simply swamping the other when it comes to being right — providing moral equivalency to both sides just comes off as condescending and thoroughly irritating. (For related reading, see: Why Stock Picking Is a Loser's Game.)

Think about it this way, in a helping an old lady cross the street vs. not helping an old lady cross the street kind of debate. 

I promise to make no effort here to hedge my conclusions. No asterisks. To me there is one clear, landslide winner in this debate and it's not even close. It’s so not close, in fact, that it is actually a misnomer to even call this a debate. A debate implies two reasoned sets of arguments in favor of one position over another that stimulate the reader to mentally sort through the arguments and end up agreeing with one view or the other, or perhaps end up at some kind of hybrid middle ground. That is not the case here.

Let me explain.

The Arguments for Mutual Funds

I will recite the pro-mutual fund arguments that I have found and then proceed to (mostly) shoot them down. They are generally out-dated, insultingly stupid, barely relevant or just plain wrong.

  • The ability to trade ETFs all day (as opposed to the once-a-day pricing of mutual funds) is a bad thing because it causes investors to be reckless and buy and sell on a whim. This to me is the most baffling and patronizing argument of all. While I do admit to struggling a bit to understand why some fellow ETF evangelists tout the all-day tradeability as such a big advantage of ETFs, I certainly do not view it as any kind of disadvantage as many mutual funders do. Just because you can do something doesn’t mean you should and doesn’t mean you will, especially if you have a decent advisor looking over your shoulder. And is it really so much more complicated to sell a mutual fund on a whim? Selling or buying either an ETF or a mutual fund these days is just a matter of a few mouse clicks in either case.
  • ETFs always carry transaction fees when buying and selling. This is an example of an outdated argument; it’s the one the mutual fund groupies wheel out all the time and it annoys me because it's just not true any more. Avoiding any transaction fee for buying or selling an ETF these days is extremely easy. Charles Schwab currently has more than 200 transaction-free ETFs (from multiple providers) in its OneSource offering, Fidelity has about 80 in its suite, TD Ameritrade has over 100. And these numbers are growing all the time. Trading Vanguard ETFs in a Vanguard account carries no transaction fee. And some robo-advisors like Betterment and Wealthfront charge zero fees for ETF transactions. Then there’s Robin Hood and all the “free trading” platforms. There’s simply no reason to pay a transaction fee for an ETF any more, unless you are looking for the more obscure, eclectic ones. And anyway, if you are buying a mutual fund on a traditional platform rather than directly from the provider, you are usually paying a fee to do that, sometimes a much heftier one than for any ETF or individual stock.
  • You pay a spread with ETFs, which you don’t with mutual funds. This is another argument based on your father’s ETFs. The spread is the difference between what you have to pay to buy something and what you will get if you sell it. Mutual funds generally do not carry a spread. Everyone selling and everyone buying on the same day does so at the same price, the so-called Net Asset Value (NAV) that day. ETFs, which trade all day on exchanges, do carry a spread (for example, if you buy a $20 ETF, it may cost you $20.10 and if you sell it, you may only get $19.90 for it, the difference being the spread), but today’s reality is that, in the case of most of the liquid, highly-traded ETFs, this spread has now narrowed so much as to be scarcely relevant.
  • It’s expensive to dollar cost average with ETFs. This is simply not the case any more, thanks to the situation described above.
  • The ETF universe contains many dangerous products like triple-leveraged inverse ETFs and may track really low-volume, obscure indexes that can damage a portfolio. It’s simple—just don’t ever use these things. Just because they exist doesn’t mean you need to buy them. It’s like saying that just because some cars are much worse quality than others, we should all go back to using a horse and buggy.
  • Some asset classes are not well served by ETFs. This is the argument with which I have the most sympathy. There are some corners of the marketplace where the ETF wrapper does not work too well at the moment, like commodities and certain areas of the bond market. But to imply that mutual funds offer a vastly better experience in these areas is a bit of a stretch. (For related reading, see: Why Procrastination Will Steal Your Future Wealth.)

And, as far as I can make out, that’s it. I have found no other reasoned attempts to argue mutual fund superiority over ETFs.

Big Advantages of ETFs

Of course, the list of ETF advantages over mutual funds is long and distinguished. I’ll just quickly rattle off ten of them.

  1. ETFs are cheaper to own than mutual funds. Usually much, much, cheaper. As in up to 90% cheaper for very similar holdings in some cases.
  2. Mutual funds carry a whole collection of additional fees that ETFs do not. Including in some cases, up to 5–6% upfront load fees, 12b-1 fees, revenue sharing fees, shareholder servicing fees, account maintenance fees, record keeping fees...
  3. ETFs have lower turnover than mutual funds. In many cases an ETF’s annual turnover may be zero. This would mean no internal transaction fees and no capital gains taxes generated. 
  4. ETFs are far more tax-efficient than mutual funds. When an ETF investor sells, then it is simply a transfer of shares from them to someone else, which does not create a capital gain. Mutual funds can create capital gains for all remaining investors every time an investor sells because the underlying shares need to be sold in order to give the money to the seller. These capital gains taxes are then passed on whoever holds the fund at the end of every year, regardless of whether they benefited from the gain or not.
  5. ETFs do not carry a minimum initial purchase amount. Many mutual funds do. And it's usually thousands of dollars.
  6. ETF holdings are far more transparent than mutual funds. You can see what is being held in your ETF on a daily basis if you want. Mutual funds are only required to show you a snapshot of what’s in them four times a year, often leading to so-called “window dressing” by the manager as the disclosure date approaches.
  7. Contrary to some rumors, ETFs do pay out dividends as frequently as mutual funds. Both are required to do so by the same Act, the Investment Company Act of 1940.
  8. ETFs do not suffer from “style drift.” This occurs when the human mutual fund manager drifts away from the investment style that may have prompted the investor to buy the fund in the first place. Since ETFs track indexes, this is not an issue.
  9. ETFs trade all day on exchanges. As I mentioned earlier, I don’t really buy into this one as being a particularly great plus for ETFs, but some other people do.
  10. The biggest reason of all: ETFs track indexes. Many mutual funds are actively managed. Mountains of data has shown that, over the long term, active management fails to match the returns of the index it tracks (depending which study you believe) 93% to 99% of the time. Active management just does not work over long periods of time.

Now, I am not suggesting that investors go out and trade in all their mutual funds for ETFs overnight, especially in a taxable account in which the mutual fund may have racked up some nice gains over the last seven years. I am saying, however, that mutual funds are markedly inferior to ETFs in virtually every aspect and I see no reason to ever use a mutual fund when a viable ETF alternative exists (which is the case in almost every asset class).

I’ll take it a step further and predict the death of the mutual fund industry in the next decade or so as investors start to understand this and the inexorable rise of ETFs inevitably makes the very mutual fund structure unsustainable and redundant. (For more, see: Mutual Fund or ETF: Which Is Right for You?)