• Your allocation needs are more important than the decision to invest in mutual funds or ETFs
• Other key factors in your choices are the type of account you have, your trading preferences and tax implications
• Looking at index returns gives you an understanding of how market conditions affect the returns of different types of index funds

Choosing a fund—whether an exchange-traded fund (ETF) or a mutual fund—involves a bit of analysis, but it doesn’t have to be complicated. Here, we make the process easy by giving some simple guidelines to help you decide which funds are right for you. Plus, we highlight AAII’s tools and resources that can make your decisions a cinch.

There are two broad starting points that will serve you well as rules to follow.

The first is to decide what your allocation needs are. AAII’s Asset Allocation Models provide sample allocation strategies for three types of investors: aggressive, moderate and conservative. The models use varying combinations of large-cap, mid-cap, small-cap, international and emerging markets stocks along with intermediate- and short-term bonds.

Below the models are ideas for the types of mutual funds and ETFs an individual investor can use to implement such strategies in a real-world portfolio. Additional ideas can be found in our AAII Asset Allocation Model article series. Allocation (“balanced”) funds and target-date funds can be used instead by those who would prefer to have a fund manager make the allocation decisions.

The PRISM Wealth-Building Process can help you recognize the appropriate allocation for each of your goals. This five-step process will help to create a personalized investment policy statement to guide your investing decisions and achieve your goals. To access PRISM and participate in the helpful PRISM Academy go to www.aaii.com/learnandplan.

The second rule is to start with broad-based index funds. These mutual funds and ETFs are typically the biggest and the lowest-cost offerings within their respective categories. They tend to offer the benefits of low expense ratios, tax-efficiency, highly diversified portfolios and above-average long-term performance.

Not all index funds are the same, so it’s important to look at which index a fund is following. A large number of ETFs follow indexes specifically designed for them to track. If you are unfamiliar with a certain index, type the index’s name plus the word “methodology” into a search engine such as Google. This will typically lead you to a document explaining what the index is designed to track.

If you are comfortable with or have a preference for active management, you can expand the universe of which mutual funds or ETFs you consider. When doing so, be cognizant of the data showing how relatively few actively managed funds are successful at beating their broad-based index counterparts over longer periods of time.

Understand the Difference Between Mutual Funds and ETFs

Mutual funds and exchange-traded funds provide individual investors access to professionally managed portfolios. They offer investors access to diversified portfolios managed at a low cost.

However, there are structural differences separating the two types of investments. ETFs trade like stocks on an intraday basis. Investors incur trading costs such as the bid/ask spread (the difference between what buyers are offering and sellers are asking). Plus, when selling an ETF, investors can immediately reinvest the proceeds.

ETFs are bought and sold from other investors. The purchase of an ETF on the open market does not add dollars to the fund’s portfolio, nor does the selling of an ETF lead to an outflow of dollars.

Rather, ETF sponsors issue and redeem shares based on interactions with authorized participants (APs). APs are typically large institutional investors. Based on demand, APs can either request creation units from the ETF sponsor or redeem them. A creation unit typically comprises 25,000 to 200,000 shares of the ETF. The actual transaction involves either a basket of securities matching the ETF’s portfolio, cash or a combination of the two.

These transactions occur on an intraday basis and help to keep the market price of an ETF’s shares close to its underlying net asset value (NAV, the value of the assets each fund’s share represents).

There’s quite a bit of information in the previous paragraphs. The big takeaway is that there are intermediaries between an ETF and the actual investors who are buying and selling shares of the fund on the open market.

Mutual funds are bought and sold only at the end of each trading day. The prices of mutual fund shares are also updated at the end of the day. When an order to purchase or redeem shares is placed by an investor, the order is not executed until the end of the trading day. These purchase and sell orders are executed at a mutual fund’s end-of-day NAV. Transaction costs—beyond any loads, redemptions or brokerage fees—are not incurred, but the dollars from such trades cannot be reinvested immediately, except into another mutual fund.

Dollars from purchases flow directly into the mutual fund. Sell orders pull money out of the mutual fund. This is why flows are often tracked. An increase in demand from investors gives a mutual fund’s manager(s) more capital to invest. Redemptions reduce the amount of capital to invest. If redemption requests are high enough, a mutual fund manager may have to sell some of the portfolio’s holdings to free up cash to fulfill the requests.

The structure of mutual funds can also lead to capital gains distributions being passed onto shareholders. These are profits from the sale of securities realized by the mutual fund that were not offset by realized losses. Investors have no control over the timing of such distributions, and there are years when mutual funds can have both disappointing returns and capital gains distributions. ETFs can also pass along capital gains distributions, but because they often fulfill redemption requests by giving APs securities from their portfolio instead of selling them, capital gains are realized less often.

Know the Factors That Influence Your Decision

So, given all of the above, how do you decide whether to use an ETF or a mutual fund?

Part of the decision rests on the type of account you are using. Participants in workplace retirement plans such as 401(k)s 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 whether the firm has a brokerage arm. (Fidelity, T. Rowe Price and Vanguard are among the fund families that allow the purchase of stocks and ETFs in addition to mutual funds.)

Discount brokers do not charge any commissions on ETF trades. Most also offer transaction-free trading on many mutual funds. Check with your broker to determine if the mutual fund you are interested in is on their transaction-free list.

Mutual funds are purchased in dollar amounts. This makes dollar-cost averaging easier and avoids the problem of having odd amounts of cash sitting uninvested. Exchange-traded funds are generally bought and sold on a per-share basis. This may make it harder to fully invest all cash. (Some discount brokers allow fractional share purchases.)

As previously noted, ETFs generally have the advantage when it comes to taxes. This is not universally the case. Mutual funds following broad indexes, such as the S&P 500 index, may also have low tax-cost ratios. The Vanguard 500 Index Admiral mutual fund (VFIAX) has a three-year tax-cost ratio of just 0.4%, for instance. This means shareholders in the highest tax bracket saw their returns reduced by four-tenths of a percentage point due to taxes.

If trading on an intraday basis is important, ETFs may be preferable. Reasons why this would matter include trading strategies and a desire to use ETFs as a placeholder in a portfolio until a new stock can be found.

A final consideration is the type of strategy preferred. Active management largely remains the domain of mutual funds, though some mutual funds have either been converted to or replicated by ETFs. (More than one-third of all ETFs are actively managed.) Factor, thematic and specialized strategies are increasingly becoming the domain of ETFs.

In many cases, mutual funds and ETFs can be interchanged. We at AAII think investors should focus more on finding the right fund for their allocation needs instead of worrying about whether it is an ETF or a mutual fund.

Pay Attention to Index Returns

Regardless of the type of fund you choose, be cognizant of the influence that market conditions have on returns. The returns of any fund—or investment strategy for that matter—are significantly influenced by the performance of its asset class.

Table 1 shows the performance of major domestic stock, foreign stock and bond indexes. These provide a benchmark for setting expectations about how particular funds should have performed.

There are two things beyond performance for the most recent year to notice. First, the best-performing index changes by year. In 2023, the S&P 500 soared by 26.3% after falling 18.1% in 2022. Treasury bills, which were 2022’s top performer, ranked 15th out of 18 in terms of largest return in 2023. This ever-changing leadership shows why diversifying across asset classes and fund groups is important.

The second thing to look at is the variation in returns. The Bloomberg US Aggregate Bond index, which tracks investment-grade bonds, realized positive returns in 2019, 2020 and 2023 but incurred losses in 2021 and 2022. These short-term swings notwithstanding, bonds have historically incurred less volatility in their returns compared to stocks. The trade-off of including both stock and bond funds in a portfolio is lower returns over the long term. Investors must balance their need for the growth of wealth over the long term against their need to preserve wealth for shorter-term goals and spending requirements, as well as their ability to withstand volatile market conditions.

Get Ideas and Analysis Tools on AAII.com

As we finalized this month’s issue, we were close to launching a redesigned interface for the online versions of our mutual fund and ETF guides. The online versions provide information on more than 23,000 mutual funds and 3,300 exchange-traded funds. The universe of mutual funds covered includes institutional, adviser and retirement mutual funds. Both load and no-load mutual funds are covered. The ETF universe includes leveraged and inverse funds as well as exchange-traded notes (ETNs).

The biggest change you will notice once the new interfaces are released is the new tabular format used to present the expanded data. We’ve also added additional information on each fund, including alpha and, for ETFs, year-to-date tracking error.

You can access the mutual fund guide at www.aaii.com/funds/mutualfundguide and the ETF guide at www.aaii.com/etfs/guide. Both guides provide the option to download the data in spreadsheet format via an Excel button (Figure 1).

To compare one or more funds, just click on the checkboxes located on the far left-hand side and then click on the “compare” button. This will call up the Compare Mutual Funds or Compare ETFs tool, respectively. As shown in Figure 2, the tools help you do side-by-side analysis of two or more funds. You’ll be able to compare returns, risk, portfolio turnover and expenses. You can also directly access either Compare tool by going to www.aaii.com/funds/compare and www.aaii.com/etfs/compare, respectively.

AAII members wishing to research a single fund can use our mutual fund and ETF evaluators. To access, type the name or ticker of the fund in the search box at the top left of www.aaii.com; when the fund appears in the autofill drop-down box, click on its name.

The evaluator (Figure 3) gives you detailed information about the fund. Here, you will find important statistics such as the fund’s size, yield, expense ratio and—for mutual funds—the minimum initial purchase amount. You’ll also notice the fund’s grades. These grades measure a fund’s returns and risk against its peers. Grades of A or B signal that the fund is performing better than its category peers for a specific statistic, such as three-year return. Grades of D or F signal that the fund is worse than its category peers.

The letter grades are calculated by segmenting the funds in each mutual fund and ETF category into quintiles (20% increments) and then assigning an A grade for mutual funds or ETFs that rank in the top 20% for any performance-related fields. A grade of F is assigned for funds that rank in the bottom 20% for any risk and expense fields (for their overall categories).

The Fund and ETF Evaluators provide annual performance data for the last 10 years (if the fund has been in existence that long), along with grades showing how the fund stacks up against other funds in its category on a year-by-year basis for performance. Standard deviation, total risk index, beta and category risk index and grade are displayed to give you insights about a fund’s risk profile. R-squared represents the percentage of a fund’s movement that can be explained by movements in the S&P 500. Higher readings imply that the fund is more closely tracking the large-cap index.

A+ Investor and Platinum subscribers have access to our redesigned mutual fund and ETF screeners, which help you identify funds that match your needs by selecting from a plethora of filters. Additionally, A+ Investor and Platinum subscribers can access our library of Mutual Fund and ETF First Cut screens.

Key Terms Used in Our Guides

These are brief definitions of some of the terms and statistics used in the fund guides. Complete field definitions can be found at the online Fund and ETF Guides.

Return (%): Total return percentages for each calendar year and average annualized returns for three-, five- and 10-year periods ending December 31, 2023. Returns are based on NAV for both mutual funds and ETFs.

Total Risk Index: The total risk index is the standard deviation of a fund’s return divided by the average standard deviation of return for all funds. Standard deviation is a measure of return volatility and is computed using monthly returns for the last three years. A value of 1.00 denotes average risk. Values above 1.00 indicate greater-than-average risk, while values below 1.00 indicate less-than-average risk. Risk numbers that are in the lowest 20% of all funds within the investment category are awarded a grade of A.

Expense Ratio (%): The sum of administrative fees and, for mutual funds, adviser management fees and 12b-1 fees, divided by the average NAV of the fund, stated as a percentage. Brokerage costs incurred by the fund are not included in the expense ratio but are instead reflected directly in NAV. Front-end loads, back-end loads, redemption fees and account activity charges are not included in this ratio. Some funds are “funds of funds,” so their expense ratios will not reflect the expenses of all funds held by the fund.

Portfolio Turnover (%): A measure of the trading activity of the fund, computed by dividing the lesser of purchases or sales for the year by the monthly average value of the securities owned by the fund during the year. Securities with maturities of less than one year are excluded from the calculation. The result is expressed as a percentage, with 100% implying a complete turnover within one year.

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