How to Choose Between ETFs and Mutual Funds
Mutual funds and exchange-traded funds have many similarities and offer investors a low-cost option to diversify for retirement. The critical difference is how these funds are managed and traded.
ETFs trade like individual stocks and are a convenient way for investors to participate in a specific sector and diversify their portfolios.
"The best fund is the lowest-cost fund that provides the most consistent return over time," says Sally Brandon, vice president of client services at Rebalance IRA in Palo Alto, California.
"ETFs are very easy to buy and when it comes time to rebalance to sell as needed in order to do that rebalancing," she says. "You can own hundreds and even thousands of stocks or bonds in one ticker using an ETF."
Unlike mutual funds, investors can easily see the underlying holdings of ETFs, which makes them a more transparent investing vehicle, says Rich Messina, managing director of financial product management at E-Trade.
"You don't immediately know what's under the hood of a mutual fund investment, so you're really relying on the fund manager's track record and expertise to meet the objectives of the fund," he says.
When it comes to mutual funds, portfolio managers can make or break a fund's returns, depending on their strategy to generate higher returns and stock choices. Mutual funds, similar to ETFs, can provide exposure to an entire sector, but are priced at the end of the trading day based on its net asset value.
ETFs typically disclose their holdings daily, whereas mutual funds do so on a quarterly basis, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA, a New York financial research company.
"The greater transparency of ETFs help keep the price in line with its net asset value and allow investors to better understand their exposure," he says.
For investing, here are a few distinctions between ETFs and mutual funds:
-- Fees tend to be lower for ETFs.
-- Mutual funds attempt to outperform benchmarks.
-- Funds are subject to different tax treatments.
-- ETFs fluctuate with intraday trades.
[Read 7 Signs it's Time to Sell an Investment.]
Fees Tend to Be Lower for ETFs
Long-term investors may find the difference between mutual funds and ETFs to be less important, but adding investments with the lowest fees yield greater returns over several decades.
Expenses are a factor for investors choosing between these two options. Mutual fund fees can be significantly larger because the fee pays for the expertise and active management of an investment professional.
"If you're simply trying to achieve diversification and greater market exposure, an ETF can do just that, so why pay more?" Messina says.
But there are mutual funds with lower expense ratios among some family funds, such as those available through Vanguard Group, Fidelity Investments and TIAA, to name a few.
While fees between 0.05% and 2% do not appear large, they add up quickly, especially if you are saving long-term for retirement and can find a less expensive option through an ETF.
[See: 7 Best Investments to Make With Your HSA.]
Mutual Funds Attempt to Outperform Benchmarks
Investors who are seeking investments to outperform benchmarks and peers often turn toward mutual funds because they are actively managed.
"It is important to understand how a fund has performed under its current manager to ascertain if they are good at selecting securities," Rosenbluth said.
One reason some investors prefer mutual funds is because the portfolio managers attempt to outperform benchmarks such as the S&P 500 or Russell 2000.
One mutual fund that has outperformed its benchmark for the last 10 years is Vanguard Wellesley Income Fund Investor Shares ( VWINX). It also has a reasonably low expense ratio at 0.23%; similar mutual funds can carry a higher expense ratio of 0.8%. But not all mutual funds outperform their benchmarks.
Funds Are Subject to Different Tax Treatments
Investors who hold these funds in a brokerage account face tax consequences. ETFs have a large tax advantage compared with mutual funds and are used by some investors to trade instead of applying a buy-and-hold investment strategy.
ETFs typically don't distribute gains if these funds are held in a brokerage account. When ETFs are held in a tax-deferred account such as a 401(k) plan or an individual retirement account, investors do not have to be concerned with paying taxes on these assets until they retire.
Mutual funds are different and pass capital gains onto the owners.
The differences in tax efficiency will generally be minimal and will only be noticeable during times of investor redemptions, says Charles Sizemore, chief investment officer of Sizemore Capital Management in Dallas.
[See: 10 Best ETFs to Buy for 2020.]
"Imagine that during the next bull market, investors start to pull their money out of index funds," he says. "This would force the managers to sell appreciated stock, which could create taxable capital gains for the fund investors. This will generally only be noticeable if the index fund faced very large redemptions, which is rare."
ETFs Fluctuate With Intraday Trades
While both mutual funds and ETFs provide diversification for investors, ETFs trade throughout the day and are subject to the market swings that come along with it.
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