What are the pros and cons of mutual funds and mutual fund ETFs?
They are very similar in that they both offer immediate diversification and management. Both can be based upon an index, sector, genre, or even strategy. The main difference is that an ETF can be traded during the day like a stock, whereas a mutual fund is sold at the end of the day and you receive the net asset value (NAV) of all of the investments within the mutual fund.
So if you are a long term investor, there really isn't too much difference. You should compare expenses between a mutual fund or ETF employing the same strategy. This would especially be true if you are using an index strategy.
If you are an active investor, an ETF offers more flexibility. Many/most active managers and individual investors use ETFs versus mutual funds for this very reason. Certain fund notable managers will specifically use a mutual fund so they cannot be mimicked or copied because a mutual fund only has to release its top 10 holdings at the end of the quarter. ETFs have to disclose holding daily. I know some fund managers that specifically structured their management as a mutual fund so large ETF players like BlackRock and others couldn't reverse engineer their strategy. The lack of transparency sometimes benefits very good managers.
So it really depends on your strategy and what you are trying to achieve. They are both a tool and not mutually exclusive. For instance, you could use a good mutual fund manager with a good strategy and then employ an index strategy using a low cost ETF. This strategy would be a combination of alpha (active) and beta (passive).
I personally prefer ETFs usually for their flexibility, but I am an active manager. Hope this provides some insight.
Best of luck, Dan Stewart CFA®
I am going to use an Investopedia article I wrote as the basis of my answer to this question.
An ETF is a vastly superior vehicle to a mutual fund by almost any measure.
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, 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.
Think of the helping an old lady cross the street vs. not helping an old lady cross the street debate.
I promise to make no effort here to hedge my conclusions. No asterisks. 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 be forced to exercise some brain power and discretion 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.
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 all-day tradeability of ETFs (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 bizarre 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 couple of 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 the hell out of me because it's just not true any more. Avoiding any transaction fee for buying or selling an ETF these days is extremely easy. Schwab currently has over 200 transaction-free ETFs (from multiple providers) in their OneSource offering, Fidelity has about 80 in their suite (they have an agreement with iShares), 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 the robos, 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 and usually a much heftier one than for any ETF or individual stock.
You pay a spread with ETFs, which you don’t with mutual funds. 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 per share and if you sell it, you may only get $19.90 per share 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 anymore. See #2. and #3.
The ETF universe contains many dangerous products like triple-leveraged inverse ETFs, for example, 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, commodities and certain areas of the bond market are examples. But to imply that mutual funds offer a vastly better experience in these areas is a bit of a stretch.
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.
Of course, the list of ETF advantages over mutual funds is long and distinguished. I’ll just quickly rattle off ten of them.
ETFs are cheaper to own than mutual funds. Usually much, much, much cheaper. As in up to 90% cheaper for very similar holdings in some cases.
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 .. the list goes on.
ETFs have lower turnover than mutual funds. In many cases an ETF’s annual turnover may be literally zero. This would mean no internal transaction fees and no capital gains taxes generated. Mutual funds often have high turnover, generating sometimes enormous transaction fees and capital gains taxes inside the fund, all of which are passed on to you, the investor.
ETFs are far more tax-efficient than mutual funds. When an ETF investor sells, then it is simply a transfer of shares from him or her 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.
ETFs do not carry a minimum initial purchase amount. Many mutual funds do. And it's usually thousands of dollars.
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.
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.
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.
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.
The biggest reason of all. ETFs track indexes. Mutual funds are mostly 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%-99% of the time. Active management just does not work over long periods of time. Out-performance of actively managed mutual funds is no more than a myth perpetrated by the companies that sell them and the commission-based advisors who get rich from convincing you to buy them.
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).
Let's first talk about how mutual funds and ETFs are the same and how they are different, and then we can get into the pros and cons of each.
The idea behind both mutual funds and ETFs are that they provide instant diversification regardless of how much money you have to invest. When you invest in a mutual fund or ETF, you are investing in a basket of stocks and/or bonds that represent a certain market such as large US companies, small US companies, international companies, etc. There are mutual funds and ETFs that cover basically every type of market you could think of.
The two biggest differences between mutual funds and ETFs are how they are traded, valued, and what their investment philosophy is. Mutual funds are traded only one time per day at market close. At the end of market close the mutual fund takes all the sell and buy orders that were placed and they calculate the NAV (net asset value) which is essentially the price or value per one share of the mutual fund. This is calculated by simply taking all the assets of the fund (securities held) and dividing it by the number of shares outstanding. ETFs are traded throughout the day, just like stocks, and the price you pay for an ETF could and most likely will be different than the NAV of the ETV. This price of the ETF like a stock is determined by demand and the future outlook of the securities the ETF owns. You can buy and sell an ETF at any time while the market is open.
Although its important to understand how mutual funds and ETFs are valued and traded, it is more important to understand the investment philosophy each vehicle represents.
Generally, mutual funds are actively-managed investments (but not in all cases). Actively-managed investments mean you pay a premium to have a mutual fund manager actively picking the stocks and/or bonds in your mutual fund. heir objective is to outperform a certain benchmark. For example, an actively managed mutual fund that invests in large US companies would most likely benchmark themselves against the S&P 500. The objective of this mutual fund would be to try and outperform the S&P 500 for any given time period. The managers do this by employing fundamental analysis and other techniques.
Generally, ETFs are passively-managed investments. Instead of trying to outperform a benchmark, an ETF simply tries to mirror the return of the benchmark. They do this by simply holding the exact same securities that their underlying benchmark holds. An ETF that represents large US companies would simply hold all 500 stocks of the S&P 500. Since there is no need for a manager to pick and choose the stocks, the expense to invest in an ETF is very low compared to mutual funds.
Now to the pros and cons:
The pros and cons of each investment are very subjective and mostly depend on your take of the stock market. If you believe that the stock market is inefficient and that a mutual fund manager can consistently outperform its benchmark then you'd invest in actively managed mutual funds. If you believe the market is efficient then you would invest in low cost ETFs.
In addition to the investment philosophies, mutual funds are generally less tax-efficient than ETFs. Since managers are actively trying to find the best stock picks, mutual funds usually have higher turnover and, therefore, more capital gains. Since ETFs simply hold the same stocks that are represented in the benchmark, there is less turnover and less capital gains generated.
Mutual Fund Pros
- The chance to outperform the stock market
Mutual Fund Cons
- Expense to invest is generally higher
- Shares only trade once a day
- Less tax-efficient
- Expense to invest is generally lower
- Your return will match the ETFs benchmark return (could be considered a con)
- Shares trade throughout the day
- More tax-efficient
- No chance of outperforming the respective benchmark
Let’s start with the basics. What is a mutual fund and what is an ETF, and how do they work?
A mutual fund is a pool of money received from investors managed by an investment company. Mutual funds issue and redeem shares at their net asset value (NAV), the price at which you can buy or sell a share that is calculated after the market closes for the day. ETF stands for exchange-traded fund and is a collection of assets that tracks an index. ETFs are traded throughout the day at their current market price and offer more trading flexibility than mutual funds.
The tax considerations are quite different. When capital gains and dividends earned in the mutual fund are paid out to investors, investors are liable for taxes on this income. ETFs are more tax-efficient because they do not pass taxes on to investors.
The cost considerations also vary widely. Mutual funds are relatively expensive. Since they are managed by an investment company, the company incurs an array of fees that cuts into returns. ETFs are significantly cheaper. ETFs are sold through brokers, rather than directly from the fund, and have lower sales and marketing fees that cut into returns. ETFs are also more accessible because they don’t have minimums, whereas mutual funds can have minimums. However, ETFs can have a brokerage commission.
Then there's the investment strategy to consider. Mutual funds are run by professional money managers who do the research to make the buying and selling decisions within the fund. The goal of this active management is to beat the market. For some investors, the allure of outperforming the market justifies the higher cost of owning the fund. ETFs are overseen by professional money managers who try to match the ETF’s performance to its benchmark index. The goal of this passive management is to track the market and not risk underperformance. For some investors, the perceived safety of a passive strategy is more desirable than the heightened uncertainty of an active strategy.
For more information, please see my article on this subject: http://www.investopedia.com/advisor-network/articles/021417/deciding-between-mutual-funds-and-etfs/
The Anatomy of Exchange Traded Funds goes through a crash course on how ETFs work. Both mutual funds and ETFs hold large diversified baskets of securities. Generally speaking, ETFs are index tracking products that trade throughout the day, tend to be lower cost, and potentially more tax efficient than their mutual fund counterparts. However, they do have limitations. Things like trading volume, the reconstitution effect, and the drawbacks from an inability to deviate from the index are worth noting.