The debate regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs), has been a hot topic in the investment industry for some time. Like any investment product, both mutual funds and ETFs have their benefits and drawbacks and are better suited to some investors than others.
Though ETFs have become rather fashionable because of their market-based trading and typically lower expense ratios, there are still solid reasons to choose mutual funds over ETFs.
The chief advantage of mutual funds that cannot be found in ETFs is variety. There is a virtually unlimited number of mutual funds available for all different types of investment strategies, risk tolerance levels and asset types.
In general, ETFs are passively managed indexed funds that invest the same securities as a chosen index in the hopes of mirroring its returns. While this is a perfectly viable investment strategy, it is pretty limiting. Mutual funds offer the same type of indexed investing options as ETFs, and they offer an impressive array of actively and passively managed options that can be fine-tuned to cater to investors' needs. Investing in mutual funds allows you to choose a product that fits your specific investment goals and risk tolerance level. Whether you want a more stable investment that generates modest returns, an investment that provides regular income each year or a more aggressive product that seeks to beat the market, there is a mutual fund for you.
Active Management Without Leverage Risk
Of course, there are some more actively managed ETFs and a newer breed of product that provides a higher-risk/higher-reward option. By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate some multiple of an index's returns. While these securities still track a given index, the use of debt to bet big without the shareholder equity to back up the gamble makes leveraged and inverse ETFs completely different species of investments.
Leveraged and inverse ETFs are the topic of much discussion because of their fickleness. Though they can be very lucrative options if the market performs as predicted, the combination of leveraged returns and day-to-day market volatility can make them dangerous investments over the long term.
Clearly, the ETF options available tend to be fairly black and white – either extremely passive indexed funds that provide moderate returns with little chance of big gains or aggressively managed high-yield funds or risky leveraged products. There is little room in the middle for investors who want a certain degree of stability with just a dash of risk. Conversely, mutual funds come in all possible combinations of security and risk.
If you want an investment that focuses on long-term capital gains, for example, you can find a mutual fund that primarily invests in proven growth stocks but also looks to benefit from early identification of up-and-coming businesses poised for exponential growth. The tried-and-tested stocks form a solid basis for long-term gains, while investments in newer or undervalued stocks provide the potential for rapid growth in exchange for a certain degree of risk. Unlike ETFs, mutual funds don't have to be all-or-nothing investments.
In addition, mutual funds are strictly limited with regard to the amount of leverage they can use. While it is possible for a mutual fund to borrow funds equal to 33.33% of its shareholder equity, most eschew the use of leverage.
ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be a slightly costlier option, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer free funds transfers, check-writing options and other shareholder services that ETFs don't provide.
Automatic Investment Options
Some of the most useful services offered by mutual funds that cannot be found investing in ETFs are automatic investment plans. These services facilitate regular contributions without you having to lift a finger, helping you grow your investment effortlessly.
By utilizing these options, you can have your mutual fund investment automatically increased by a predetermined amount each month. This provides an easy way to grow your nest egg without having to make the monthly decision to allocate those funds to your portfolio or use them for other things. Given a few hundred dollars of discretionary income each month and the choice of how to use it, many people might elect to spend it on non-essential activities or purchases rather than making the smart choice of investing it. An automatic investment plan makes that choice for you.
In addition, mutual funds often offer dividend reinvestment plans (DRIPs) that allow you to use any dividend income generated by the fund to purchase additional shares. Like an automatic investment plan, DRIPs take the stress of decision-making out of the equation by automatically converting dividend distributions into investment growth.
No Commission Fees
Another reason mutual funds can be the better option is if your investment plan includes incremental investment over time. While ETFs are often touted as the cheaper option because of their relatively low expense ratios, shareholders still have to pay broker commissions each time they buy or sell shares. If you plan to make one large investment, ETFs may be the cheaper option if one of the products available can meet your investment goals.
Many people, however, prefer to grow their investments over time. This gives you the chance to see how a product performs before committing fully, and it can be a much more sustainable investment strategy. Not everyone has $10,000 or more to invest all at once. In addition, the practice of investing a set amount each month, called dollar-cost averaging, means you will end up paying less per share over time; you will purchase more shares with the same amount of money in months when the share price is low.
Though mutual funds sometimes carry up-front fees for first-time investors, they make it cheap and easy to increase your investment down the road. In addition, the availability of the automatic investment and DRIP options makes incremental mutual fund investment virtually effortless. To build your ETF investment in the same manner, you would incur commission or transaction fees each month, which can substantially reduce your take-home profit.
Though both mutual funds and ETFs can be smart investment choices, there are some clear reasons why mutual funds may be the better choice, depending on your investment goals and strategy. However, there's no reason you cannot further diversify your portfolio by investing in both asset types if they serve your long-term goals in different ways.