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Choosing Between Mutual Funds and ETFs

by Charles Rotblut, CFA

The decision to own a mutual fund or an exchange-traded fund (ETF) is dependent on a variety factors. Both types of investments have advantages, but individual investors should not feel compelled to switch from one to another. Rather, investors should first consider the following factors and then consider the investment that is best for them.

What Are Your Portfolio Diversification Needs?

The first step when choosing among funds is to determine what your portfolio needs are. For example, do you need exposure to domestic small-cap stocks or municipal bonds? The answer to this question will be determined by what asset classes further diversify your portfolio and keep your investing risk within your tolerance limits.

Knowing what asset classes you want to target helps you in two ways. First, it narrows your search to a smaller, more targeted group of funds. Secondly, it makes comparisons between funds easier. A fund investing in emerging market debt will have different return characteristics and higher expenses than a fund that invests in U.S. blue-chip companies.

Active or Passive Management?

Once you know what your portfolio needs are, you can start to consider whether you want to use an active or passive strategy.

Active strategies rely on the ability of the fund manager to handpick the securities. Active managers attempt to beat their benchmark index (e.g., the S&P 500) or produce a portfolio that is either less volatile or less correlated with the benchmark. The inherent danger is that the fund manager fails to do so. Active management can result in higher expenses and greater turnover.

Passive strategies attempt to mimic the return characteristics of a benchmark index. Passively managed funds charge lower expense fees than their actively managed counterparts. An inherent danger is that a passively managed fund fails to accurately mimic the performance of the benchmark index and incurs tracking error. Plus, as exchange-traded funds have grown, so has the number of indexes designed for ETFs to track.

“Enhanced indexes” fall into a grey territory between active and passive approaches. Though funds that track these indexes are technically following a passive approach, the indexes themselves are designed to track an anomaly or a group of characteristics that may result in better performance than a well-known index. Again, the dangers of underperformance and higher expenses exist.

Mutual funds remain the only viable choice for low-cost exposure to active strategies, with very few ETFs following active strategies (though this could change). For passive strategies, ETFs tend to charge lower annual expense fees than their mutual fund counterparts.

Portfolio Composition

When looking at active and passively managed portfolios, you should also consider the securities held. Similar sounding funds can have vastly different holdings. (ETFs update their holdings much more frequently than mutual funds do.)

Index funds tend to overweight the largest companies within the index. For example, as of the end of January 2012, Apple (AAPL) and Exxon Mobil (XOM) comprise approximately 7% of the SPDR S&P 500 ETF (SPY). Depending on how the index is structured, a few companies can have a very significant impact on the fund’s performance.

Actively managed funds may also overweight large companies. Alternatively, they emphasize certain sectors in an attempt to boost performance. Managers who target securities that are less liquid, such as micro-cap stocks or smaller foreign markets, may incur more volatility or have problems replicating past performance if their fund attracts too much investor dollars. (Mutual funds can close themselves off to new investors, while ETFs cannot.)

This is why, when looking at a mutual fund or an ETF, you should always read the prospectus and understand exactly what the fund invests in. Only invest in funds whose portfolio strategies you understand and are comfortable owning.

Your Personal Situation

Finally, you should consider your personal situation. Most 401(k) plans only offer mutual funds to participants. (Some do offer ETFs, however.) Individual accounts, both taxable and tax-deferred (e.g., IRAs) can be invested in mutual funds or ETFs. If your portfolio is invested directly with a mutual fund family (e.g., T. Rowe Price, Dodge & Cox, etc.), you will have to transfer money to a brokerage account in order to buy ETFs. (Unlike most mutual fund families, Fidelity and Vanguard do operate their own brokerage units.)

When choosing between a mutual fund and an ETF, go with the fund that best suits your needs. If it is a close call between a mutual fund and an ETF, the lower-cost option may be the best choice. Pay attention to any fees you may incur by making the change, such as brokerage commissions and transfer fees, since these can impact your overall cost savings.

Finally, do not feel compelled to alter your portfolio just for the sake of change. If you are happy with your current fund holdings, do not transfer your money out of them.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Dave from CA posted over 2 years ago:

Another consideration is how frequently an investor intends to trade. Many mutual funds discourage or forbid in and out trades to the same fund within a 30-day period. There is no such time barrier with ETFs.


Howard from CA posted over 2 years ago:

Is there a screener that allows you to compare mutualfunds to ETFs?


Charles from IL posted over 2 years ago:

Howard, I have not seen one. While admittedly not a perfect a solution, you could download the spreadsheet for our mutual fund guide and our ETF guide to compare funds in similar categories. All of our guides are can be found at http://www.aaii.com/guides. -Charles Rotblut


Israel from NY posted over 2 years ago:

etfs are less expensive, and some brokerags do not charge commission.
izzy


Robert from MD posted over 2 years ago:

Howard, use Fidelity.com, select Research then mutual funds, select any Fidelity mutual and on that page you can compare any combination of four other mutual and/or ETFs.


Mark b. from NH posted over 2 years ago:

Vanguard offers the same service.

Charles, your columns and monthly messages are excellent. A great new addition. Thanks.
Mark


Ken from CA posted over 2 years ago:

ETFs allow you to check the price during the day, and to place limit orders or to trade during the day. That way you can know the price which you pay or price which you get. With mutual funds you don't know the price during the day and have to put in an order ahead of closing and get the closing price which is unknown when the order is placed.

Vanguard has several ETFs the are the same as their mutual funds, so with those you can choose either a mutual fund or ETF and get the same investment.


Anthony from NY posted over 2 years ago:

Is there a mutual fund or ETF composed solely of other ETFs so that you can obtain a portfolio of various investing strategies or allocation theories by investing in only one ETF?


Yefim from CA posted over 2 years ago:

Yes, check the UNBOX fund in the Morning Star. This is FUNDX ETF Aggressive Upgrader that consis solely of othe ETFs.


Habeeb from MI posted over 2 years ago:

What about tax implications? I have to pay significant taxes on LT distributions for Vanguard Energy Fund even though I didn't buy or sell any shares - I've been thinking of switching over my portfolio to ETFs.


Charles from IL posted over 2 years ago:

Habeeb-The tax implications depend on how the fund is managed. Both our Mutual Fund and ETF guide show how tax efficient each fund is. -Charles Rotblut, AAII


Charles from IL posted over 2 years ago:

Mark, thanks for the kind words. -Charles Rotblut, AAII


Roy from CA posted over 2 years ago:

You did not mention that ETFs can trade at a discount or premium to their net asset value. How big a problem is that, particulary if they are at a discount when you want to sell?

Also, ETFs are supposed to be more tax efficient because they don't have to sell shares to meet redemptions. I do not know from real world experience how much difference that makes, particularly as compared to large funds that have cash reserves to handle redemptions.


Howard from CA posted over 2 years ago:

Thanks all for your help comparing ETFs with mutual funds.I tried Fidelity using both their ETF screen and their mutual fund screen but they don't include any data other than the NAV. Vanguard does allow you to compare ETFs and Mutual funds both theirs and other ETFs and mutual funds but the depth of their info is less than Fidelity's so I think you need to use both. Thanks again for your input.


John from VA posted over 2 years ago:

Has anyone compared the bottom line cost of trading ETF's versus individual stocks? I am looking at my first ETF buy, considering PIMCO TRXT available starting 3/1/12. Schwab charges $8.xx per stock trade. Will the fund costs be prorated and deducted from the net sale amount?

Thanks


IOD from CA posted over 2 years ago:

I find Charles and Mark B.'s comments most instructive. Yes, you don't have as much strike price control with a mutual fund, but have to check to make sure you are choosing the right strike price when buying or selling an ETF, because NAV may be over or under-priced with ETFs.

In the end, I wish I had created my company's 401k plan with a company that allows ETFs within the 401k plan. Instead I went with Vanguard, which has some good mutual funds, but is not giving me the granular diversification I could get with ETFs. Vanguard has ETFs, but they can't be purchased in the 401k, only within the IRA or non-retirement brokerage accounts.


Alex from CA posted over 2 years ago:

Indigo, my employer's 401k is with Vanguard, and I had no problems placing most of the account's worth in a Vanguard's "brokerage window" where I can trade stocks and ETFs to my heart's content (on most of them, but not all, I can also choose commission-free, fractional-shares automatic dividend reinvestment). [I do also keep a few Vanguard mutual funds there, and those are where my monthly contributions and my employer's matching thereof automatically go every month].

Also, for at least some number of trades per month on the "brokerage window" (far more than I need, I don't trade very actively at all there), I pay a wonderful commission of just $2.

I imagine it's just a question of negotiating with Vanguard exactly what is going to be allowed to employees in the 401k and at what cost -- my employer is a large, financially savvy company with a well-deserved reputation for looking after employees, so I guess they had both the negotiating leverage and motivation to haggle;-).


El from IL posted over 2 years ago:

I use indexed ETF's as core holdings and switched most of my mutual fund holdings in my taxable account to ETF's a few years ago. I got tired of actively managed MF year end short term (taxed as ordinary income) and long term (taxed as capital gains) distributions, especially when they lost value in 2000. Many were surprises with little warning or planning time.

With actively managed MF's I also checked Portfolio Turnover, the % of the MF holdings sold annually. The higher that number the more likely distributions would be short term. Now with ETF's I control what price I pay, what price I sell at, when I take gains or losses and their yield from dividends. Yes, NAV comes into play but since they are core holdings I plan to keep them for a longer time period which negates much of that problem.

Like indexed MF's, currently there is a wide variety of indexed ETF's that should satisfy most of your needs.

Something I didn't see discussed was the advantage of options on ETF's. The August 2010 issue had an article entitled "The Covered Call: An Income-Generating Options Strategy"


PG from NY posted over 2 years ago:

I've started using jemstep.com to get another angle on my 401K and IRA holdings. I don't rely on its advice 100%, but it's a good sanity check to use for confirming the results of other screeners. It's a fairly new web site (started in Oct. I think), but they're off to a good start from what I can see so far. Very user-friendly and slick-looking. I'd love to see AAII do a review of jemstep sometime!


Richard from CT posted over 2 years ago:

I have found the only time it makes sense to buy actively managed mutual funds is when they meet the following criteria: Low load, current manager for at least five years,low turnover,fund manager a major investor in his own funds,clear & understandable investment strategy and evidence it is followed,close the fund to new investors when there are not enough opportunities to profitably follow the stated investment strategy,acheived significantly better performance than its benchmark for the last five to ten years at a atandard deviation no greater than the benchmark and heavily weight how the fund did during the most recent major decline in the stock market. If you cannot find funds meeting these criteria go buy the ETF/ETFs that mirrors the index t6hat meets your need.


Sharon from NJ posted over 2 years ago:

I'm some what of a passive investor. I use mutual funds, because they allows me to automate purchasing new shares as I put more money in my brokerage account. With ETFs, I have to purchase manually.


Jim from CT posted over 2 years ago:

Kendal

If you want a "fund" of ETFs you should look at Fidelity's Portfolio Builder tool found under the Research>ETF tabs on the account page.

It allows you to enter an number of ETFs, set allocation by dollar amount or % of investment and then save the "basket" for trading. If you make a basket you can purchase the basket as a group. This might simplify dollar cost averaging into a diversified group of ETFs.

I have not used the feature yet but I am considering a test drive.


Philip Sagle from VA posted over 2 years ago:

RE: PG from New York


"[...] Jemstep does not guarantee any confidentiality with respect to any User Submissions. [...]"

SOURCE: 'Jemstep Website terms of use.'; 5. User Submissions; (a) General; end-of-1st-and-only-paragraph
http://www.jemstep.com/compliance/terms-of-use

Enjoy your "Internet Freedom"!


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