The mutual funds vs. exchange-traded funds debate has been a popular one in recent years. Mutual funds are like that old crafty boxer who trains hard in order to prove he's still champ. ETFs are akin to the young, hungry boxer with a high threshold for pain but also with a high propensity to take risks. The right investment for you depends on your investing strategy, time frame, risk tolerance, and other factors. (For more, see: Mutual Funds vs. ETFs.)
Arguments can be made for — and against — both mutual funds and ETFs, but let's focus on the pros of the latter:
- Higher Fees — The average expense ratio for an ETF is 0.43%, compared with the 1.4% average for a mutual fund.
- It’s important to note that expense ratios can range widely. For instance, the expense ratio on most leveraged ETFs is 0.95%; just below 1% for psychological reasons (similar to pricing something at $9.95 instead of $10.00). On the other hand, you can even find ETF expense ratios as low as 0.04%. Most with low expense ratios that low are passively managed, meaning they have the set-it-and-forget-it strategy of tracking an index. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)
- Transparency — If you want to see your holdings at any time you please, as well as what percentage of net assets those holdings represent, you should strongly consider opting for an ETF over a mutual fund. An ETF will disclose its holdings daily, whereas a mutual find discloses its holdings either monthly or quarterly (with a lag). (For more, see: Exchange Traded Funds FAQs.)
- Specificity — If you do your research and know without a doubt that gold is going lower, you could invest in (or trade) an ETF that shorts gold. Or, if you're certain health care stocks are going to appreciate, you could find an ETF that specifically tracks health care. These days, it’s possible to find almost any type of ETF — if there's something to track, there’s a good chance you'll be able to find an ETF for it.
- The one issue here is a lack of liquidity. If you find a low-volume ETF with a wide bid-ask spread, it could end up costing you extra. Be sure to use a limit order to protect capital. On the other hand, if it’s a low-volume ETF tracking something that has yet to see a parabolic move, you could get in ahead of the curve and make a lot of money. (For more, see: Using a Limit Order With a Bid-Ask Spread.)
- Mutual funds are known for their diversification, which helps preserve capital, but this is also going to significantly reduce your upside potential. The real secret about mutual funds is that they exist to make mutual fund managers money. The goal isn’t to crush the market; it’s to do just well enough to keep investors interested, which will lead to continuous management fees. And if the market tanks, it’s the market’s fault because the mutual fund was diversified, which is apparently “the best protection” you can have. In reality, the best protection you can have is knowledge, which is based on a lot of research. If you put the time in, you will be rewarded. (For more, see: Stop Paying High Mutual Fund Fees.)
- Tax Advantage — An ETF acts just like a stock, and your capital gains are based on when you sell. Therefore, you have full control. With a mutual fund, it’s possible you'll have to pay taxes even if you lost money because you jumped into the fund late in the year and there are embedded gains. In other words, you have to pay taxes for what took place earlier in the year (and in which you didn't even participate). Another negative for mutual funds here is that a mutual fund manager might sell winners in a down year for marketing purposes. (For more, see: Capital Gains and Taxes: What You Need to Know.)
- Liquidity — If you want to be able to move in and out of your investment(s), investing in ETFs over mutual funds should be an easy decision. With an ETF, you also will be able to use margin, sell short, and trade futures and options. (For more, see: Why Is Short Selling Legal? A Brief History.)
The Bottom Line
If you desire lower fees, transparency, the option to invest in specific markets, tax advantages, and liquidity, you should consider ETFs over mutual funds. The only real reason to consider mutual funds is to attempt to keep yourself out of trouble by not getting emotional and trading too much with ETFs. But mutual funds don’t present shorting options and therefore can present their own dangers in bear markets. (For more, see: Why ETFs Often Edge Out Mutual Funds.)