Considerations for Picking a Mutual Fund or ETF

If your investing plan calls for incorporating funds into your portfolio strategy, you will first need to answer two basic questions: Which areas of your allocation are looking to fill? Are you going to invest in mutual funds or exchange-traded funds (ETFs)?

The process of picking a fund should always start with your allocation strategy. Researching a great-performing small-cap value fund when you need to fill the bond component of your portfolio doesn’t help much. It’s akin to looking at kitchen appliances when your air conditioner has stopped working in the middle of the summer heat; you should focus on finding someone who does air conditioning repairs.

Once you decide which asset class to target, you can start to drill down by fund group and category. From there you can pick the best fund for your needs. Look at returns over several time periods (as opposed to simply one year or even shorter time periods), the level of risk relative to peers and the expense ratio. If the fund is to be held in a taxable account, look at the tax-cost ratio. These analyses can be done using our mutual fund and ETF comparison tools. You can find even more useful tools and data—including lists of consistent performers and performance benchmarks—in the mutual fund and ETF sections of AAII.com. 

Your choice of which type of fund to invest in starts with the account you are using. Participants in workplace retirement plans like 401(k) plans are generally limited to mutual funds. Most robo-advisers use ETFs. If you have an account with a mutual fund provider, then your options depend on the company. If your account is with a mutual fund company without a brokerage arm, then you are limited to mutual funds. Fidelity and Vanguard are among the small group of fund families to allow taxable, IRA and Roth IRA account holders (as well as those with similar types of accounts) to buy stocks, ETFs or mutual funds.

The major discount brokerage firms do not charge commissions on ETF trades. Certain mutual funds can be traded on a no-transaction basis, though the list of funds varies by broker. (Minimum holding periods may be required, though you shouldn’t be jumping in and out of mutual funds anyway.) Mutual funds facilitate fractional share purchases, which is helpful for those who dollar-cost average as well as those with smaller account balances. Fidelity (only via its app) and Interactive Brokers allow fractional share purchases of ETFs as well.

Mutual funds are bought and sold at their net asset value (NAV) at the end of the day. When you put $100 into a mutual fund (assuming no transaction fees or front-end loads), you are investing in $100 of the fund’s assets. Active management remains predominantly in the mutual fund arena (the number of actively managed ETFs is small). Mutual funds also offer far more options than ETFs for those seeking to hand over portfolio allocation to a fund manager. Target-date funds are one such example.

ETFs can be bought and sold throughout the trading day. While the largest ETFs trade at or very close to their NAV, the smaller ones can trade at premiums or discounts to their NAVs. In the latter case, investing $100 may get you more or less than $100 in assets. The overwhelming majority of ETFs track indexes. How purely passive they are depends on one’s perception. Much of the growth in indexed factor (aka, smart beta) approaches has occurred on the ETF side. (Many mutual funds follow a style, like value or growth, but do not specifically use a quantitative factor strategy.)

Pure index investors can find both ETFs and mutual funds tracking the broad traditional indexes. The expense ratios are comparable at the lower end.

In many cases, mutual funds and ETFs can be interchanged. Investors seeking active management, allocation strategies and the ability to dollar-cost average may find mutual funds more suitable. ETFs work well for getting index-based approaches to factors, styles and/or sectors and industries. They also offer the ability to buy and sell on an intraday basis. This characteristic matters if you are looking to put excess cash to work in your portfolio and/or need a temporary placeholder to invest in after having sold a stock but don’t yet have a replacement candidate in mind.

ETFs have an edge when it comes to taxes. ETF sponsors interact with authorized participants (APs). These large institutional investors and trading firms are comfortable taking in-kind distributions, which means accepting securities in lieu of cash. While mutual funds may allow in-kind distributions, the thresholds are too high for most individual investors. The combination of having a greater demand for cash redemptions and the lack of in-kind redemptions to use for removing securities that have risen in value since purchase causes higher taxable distributions to be passed along to mutual fund shareholders. Investors have no control over the timing of such distributions and there are years when mutual funds can have both disappointing returns and high capital gains distributions. ETFs’ use of APs prevents this from happening. Note that not all ETFs are tax-efficient; depending on the strategy followed, some ETFs can have high tax-cost ratios as well.

One way to get around the tax issue is to use tax location. Hold more tax-efficient funds in taxable accounts. Place less tax-efficient funds in tax-preferred accounts such as traditional IRAs and Roth IRAs. For example, you could hold index-based ETFs in your taxable accounts and actively managed mutual funds in your retirement accounts. Doing so would allow you to avoid paying taxes on the mutual fund distributions. (The tax-cost ratio, which is included in our mutual fund and ETF guides, shows you how tax-friendly or unfriendly a particular fund is.)