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Pros & Cons of Mutual Funds vs ETFs

What's the perfect investment to ensure financial security? See the pros and cons of mutual funds vs ETFs to figure out which one suits you the most.

Trauma from the 2008 financial crisis affects America's perception of what people think are profitable investments. Stocks are extremely susceptible to market swings, especially during times of volatility caused by economic shock. This insight likely influenced the people who participated in a study by Bankrate, where just 17 percent of people listed stocks as the best way to invest money for the long run. Stocks lost out to real estate at 30 percent and 23 percent of people who preferred cash investments. While it may churn stomachs to lose a large percentage of one’s stock investments in one day or a month—historical data shows that stocks always bounce back. While historical data is not always a predictor of future results, you can trust financial advisors and economic historians by dipping your toes into investing. Learn about the pros & cons of mutual funds vs ETFs to get over your fears of investing.

The Advantages of Value Investing

Investing in stocks or equities is just as easy buying or selling a house, or setting up a bank account. Don’t let the world of finance intimidate you with its jargon. Follow Warren Buffet’s simple advice about value investing by buying index funds that match the performance of a market—the tip is to not worry about short-term fluctuations. The most popular way to do that is by buying shares of a passively managed ETF. Buffet's profound advice about investing is also matched by great advice about life. A more aggressive, yet diverse approach to investing is mutual funds.

The Advantages of Mutual Funds

Mutual funds are an easy way to invest in the stock market. They offer a diverse portfolio of assets, professional management, low investment minimums, and have become a staple for many investors since the 1920s. Prices for mutual funds are set by the end of the day, and cannot be traded intraday.

What is an ETF?

Exchange-traded funds, or ETFs, are similar to mutual funds in that they can provide investors a mix of different assets, but are different in that they are traded like stocks. ETFs' prices are determined by market forces of supply and demand, making them well suited for investors engaged in intraday trading.

ETFs are more liquid and offer flexibility.

Since ETFs are traded like stocks, they are priced on what investors think the current or future value of the basket of assets are. Investors can only buy shares of a mutual fund after the market has closed and the price is determined on the Net Asset Value—the value of fund assets minus liabilities divided by the number of shares. While liquidity may seem attractive, it can also be a pitfall for investors. Active trading can lead some day traders to chase past performances and make risky bets.

This flexibility comes at a cost.

When ETFs are bought and sold, a commission fee is often paid to the investment fund. Thankfully, market competition has worked out for the average investor and some ETFs are commission free. Be careful though, some funds compensate their lack of commission with higher management fees. Luckily, competition in the space has also pushed the management fees for some ETFs down to zero as well.

There are mutual fund fees?

Mutual funds are great because they allow investors to trade without paying a commission fee. However this comes at a cost—management fees are likely to be greater than ETFs. In 2016, the average expense ratio of index ETFs was just 0.23 percent compared with a 0.82 percent average expense ratio of actively managed mutual funds, and a 0.27 percent expense ratio for index equity mutual funds, according to Investment Company Institute.

ETFs save you on taxes.

Since investors time when they buy and sell their stake in ETFs, accounting for capital gains tax or loss is a personal endeavor. Due to the more diverse portfolio allocation of mutual funds and taxable items to account for, such as interest, dividends, and capital gains, mutual funds have more complicated tax implications. However, it's important to consider whether the ETF or mutual fund is held within a taxable account, and not within a tax-advantaged retirement account, such as an IRA or 401(k). Overall, for the average investor, ETFs will likely be more tax efficient than mutual funds.

It's not timing the market, it is time in the market.

Assets within mutual funds are likely to be more actively traded. Since most ETFs are index funds, which track a market's index, they will only change their allocation of assets based on the movement of the market it's tracking. A mutual fund’s asset allocation will be determined by a portfolio manager, and will hope to outperform the market. Active management by a portfolio manager is only a good thing when they can outperform the market on a consistent basis. Back to Warren Buffet’s advice about value investing through index funds, he bet one million dollars with a hedge fund that they could not beat the performance of the S&P 500 over a ten year period. Warren Buffet won. Hopefully, this challenges common perceptions about needing an actively managed portfolio and investing in passively managed funds.

There's an option for every budget.

Regardless of your investment goals, there are ETFs and mutual funds for every budget. While many funds in both categories require a minimum investment, there are plenty for those wanting to take on minimum risk.

Investors should consider the effects of the paradox of choice.

Mutual funds are the straightforward winner when it comes to selection and variety. While ETF variety has grown significantly since its inception in 1993, it still falls short of mutual funds. Fidelity offers investors a wide variety of mutual funds, with 3,600 commission free options—compared to only 90 commission free ETFs. Meanwhile, TD Ameritrade gives its investors access to more than 4,000 transaction-fee-free mutual funds and around 100 commission-free ETFs. The average investor rarely struggles to find an ETF that meets their investing needs, but it has room to improve. 

Which one is better?

The pros & cons of mutual funds vs ETFs do not leave a conclusive winner; every person must decide their own financial strategy. Investors can trade ETFs like stocks, but commission and management fees can eat away at profits. Mutual funds have higher management fees because portfolio managers try to beat the market index by choosing their allocation of assets. For someone who likes to control their investments and appreciates Warren Buffet’s advice about passive investing, ETFs are the clear winner. For those who think their portfolio manager is smart enough to beat the market year after year, mutual funds are king.

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