Mutual Funds vs. ETFs

Mutual Funds vs. ETFs

August 25, 2021
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Let's talk investment vehicles.  Mutual Funds vs ETFs: Differences, similarities, and which one might be right for you. 

Many beginner investors have at least heard about the principle of diversification, which theoretically states that the more uncorrelated stocks you own, the less risk your portfolio possesses. Purely in the context of diversification, there are many ways a beginner investor can adhere to this principle. The most obvious way is to choose many individual stocks that represent different industries (and are, therefore, uncorrelated). However, this process comes with a few downsides: it involves researching each individual stock, executing each trade, paying a commission for each trade, and then actively monitoring the performance of each stock in the portfolio. For those who don’t have the expertise or enough time to conduct the research, there are two easy and effective ways to achieve built-in diversification: investing in diversified mutual funds and/or ETFs. 

Mutual funds and ETFs are both essentially bundles of stocks, selected and maintained by investment professionals/portfolio managers. Therefore, rather than hand-selecting each stock on your own, one can simply invest in either a mutual fund or ETF and achieve instant diversification. 

Mutual funds are typically actively managed by a fund manager whose job is to monitor the individual holdings and make buying/selling decisions based on their analysis-based predictions. This is why mutual funds command an “active management fee” of roughly 1-2% of the investment (for instance, if $5,000 dollars were invested into a given mutual fund, the active management fee would be between $50 and $100). 

ETFs (Exchange-traded funds) are largely structured as passive investments (they aren’t necessarily actively managed) and, thus, their fees can be less.  Although a passive strategy may seem like a downside, it’s by design. The stocks in most ETFs mirror an index (like the S&P 500 or Nasdaq), so the performance of the ETF closely tracks the performance of the index. ETFs trade all day on an exchange, just like a stock. 

There’s a tradeoff between the active management of mutual funds and the lower fees of ETFs. Most stock-market investors fail to outperform benchmark indexes. Not even professional money managers are able to beat major indexes regularly. Given this phenomenon, it may seem illogical to invest in mutual funds, right? ETFs sound pretty good now, right? Consider this:

Consider what might happen if the index your ETF is tracking starts to slide. If the ETF is passive, there won’t be an active manager who can implement internal safeguards. This makes a case for an actively managed fund (but, of course, active management isn’t a panacea, and the manager can just as easily underperform the index).  

So, which is better? Mutual funds or ETFs?  Ultimately, that’s an irrelevant question.  One isn’t better than the other. Rather, one is more appropriate than the other.  The direction you and your advisor choose will depend on your goals, risk tolerance, investment strategy, etc.  Each investor will have to weigh the pros and cons of each approach and decide which is most appropriate. 

Even with this information, choosing between mutual funds and ETFs can be complicated, so please reach out to your financial advisor for more clarification. Feel free to contact us as well - we are happy to talk through this concept in more detail and figure out which investment vehicle is right for you. 

 

*Mutual funds and ETFs can be passively or actively managed, so please carefully research the underlying strategy before investing. 

*Mutual funds are priced once at the end of each trading day.  They’re not actively traded on the stock market, rather, they’re bought and redeemed directly through the sponsoring institution. ETFs are actively traded on an exchange in the secondary market.  They’re traded directly between investors.