Investors can use both options to establish a low-cost, well-diversified portfolio of stocks, bonds, and other assets, including, for those so inclined, Bitcoin.
Mutual funds remain the top dog in terms of total assets thanks to their prominence in workplace retirement plans, such as 401(k)s. U.S. equity mutual funds have around $6.3 trillion compared to $1.6 for ETFs, per Morningstar. ETFs, meanwhile, are attracting the lion’s share of new investment dollars.
They key is to understand how the relative advantages of ETFs and mutual funds correspond to your priorities as an investor. There is no perfect fund, there are only funds ideal for you.
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What both mutual funds and ETFs do well
Investors can use mutual funds and ETFs to buy a wide swatch of stocks or bonds without making too large a bet on any one company or sector.
Take the S&P 500. You can buy the entire index, and the gains of the nation’s largest companies that comprise the list, for a minimal amount with either the Schwab S&P 500 (a mutual fund) or SPDR S&P 500 ETF (an exchange-traded fund). You don’t, then, need to make a specific bet on what General Electric or Apple will do over the next year or so, you can instead bet on American economic growth.
Both options charge investors extraordinarily low fees, in this case the mutual fund actually beats out the ETF. In fact, you can easily create a fully diversified portfolio with only three mutual funds or ETFs, using solely one or the other.
Active management vs. passive management
There are some differences—philosophical and technical—that you need to consider before picking an investment choice.
Mutual funds generally break down into two categories: actively-managed and passive. The latter track an index, like the S&P 500, in an effort to deliver market returns to its customers. These are low-fee and make no ostentatious claims – you will be the market, rather than beat it.
Actively-managed fare, on the other hand, employ a person, or group of people, to pick which stocks, in the case of equity funds, to buy and which to sell and when. These funds hope to beat the market, and charge higher fees than passive funds.
Some can back it up. Dodge & Cox Stock, an active fund, beat 89 percent over its peers over the past 15 years, taking in an annual average of 10.44 percent, slightly higher than the market as a whole.
Most, though, cannot. Over a 15-year period, according to the S&P Dow Jones Indices Scorecard, 85 percent of active U.S. equity funds that invest in large companies failed to beat their benchmark.
Looking for a less risky investment? Certificates of deposit are a great way to go.
Commissions stack up
Of course, you can passively track an index with an ETF, too. If you want to take what the market gives you, which option is preferable? It all comes down to how you trade, assuming a mutual fund and ETF charge similar fees.
If you’re planning on using dollar-cost averaging, where you make predictable contributions to a fund, you’re better off going with a mutual fund. That’s because many mutual funds are available with no transaction fees and no sales commissions. ETF customers might have to pay trading commissions, making frequent buying and selling expensive.
That can add up. Assume someone invests $500 on a biweekly basis in both an ETF and a mutual fund. Both investments get 8 percent annual returns, net of their expense ratio. The only difference is that the investor pays an $8 commission biweekly with the ETF. After 10 years, this is what the investor has accumulated in the two funds:
Sometimes you have to eat the bullet, though. Unlike most mutual funds, ETFs don’t have a minimum requirement, so investors can buy only a few shares, a positive for an investing novice. Small investors can avoid commissions altogether by seeking out no-commission ETFs.
Watch out for taxes
Mutual funds can expose you to a higher tax bill. Even if the mutual fund isn’t trading a bunch of stocks as part of its strategy, the act of simply redeeming shares for outgoing investors can force managers to sell shares of the investments in the fund.
Any taxes incurred from the sale are paid by shareholders at the end of the year. Even if you buy the fund late in the year, you could still be paying a tax bill for events that happened before you made the investment, thanks to what are known as embedded gains.
But don’t let taxes be the determining factor in your decision. You’re looking for a long-term investment at a low-cost.
The right answer, then, is to pick a set of funds that align with your risk tolerance, give you broad exposure to companies around the world and don’t charge all that much. If you get that down, you’ll do fine.