ETFs or Mutual Funds? That’s The Question!

Before we answer this question, let’s see what each of these investment vehicles has to offer you and your investment portfolio.

Mutual Funds

Mutual funds came on the scene way before the first ETF started trading. In fact, the first mutual fund, as we know them today, was created in 1924.

Mutual funds provide 2 key benefits to individual investors:

  • Active management through a fund manager
  • Diversification at a relatively low cost

Mutual fund companies pool the money of many investors and hire a professional fund manager, who then invests the pooled money by picking investments according to the fund’s objectives.

The main goal of the fund manager is to outperform the stated benchmark for the fund.

In return for giving your money, you get shares in the fund in proportion to your investment.

The price of each share, the fund’s net asset value (NAV) is

Mutual Fund Net Asset Value Formula

 

Fund companies issue shares when more investors want in and reduce share count when investors want out.

Mutual Fund Fees

Active management offered by mutual funds does not come cheap. Most mutual funds are riddled with all kinds of fees that eat into your wealth.

[RELATED: How do mutual fund fees Quietly eat into your wealth? ]

For example, morning star shows the following for the fund ticker: GFACX.

GFACX Mutual Fund Performance

You can see this fund has a load of 1% and ongoing expenses of 1.46% which are on the high end. It’s ironic Morning star thinks the fees of 1.46% are low.

Check out ETF alternatives that YourCapital lists for GFACX, assuming you invested $1,000 in GFACX.

GFACX alternative recommendations

Load

Load is generally the commission brokers get for selling you, the investor, an expensive fund.

Your money pays for the broker commission and in the case of GFACX, only 99% of your money actually gets invested in the fund.

Expenses

The ongoing expenses for GFACX at 1.46% are also on the high end. On average mutual funds charge 1% and ETFs, which we will discuss later, have significantly lower fees.

Morningstar study shows that once you take fees into account, most active managers do not outperform their benchmark. One of the key findings of the study:

Investors would have substantially improved their odds of success by favoring inexpensive funds, as evidenced by the higher success-ratios of the lowest-cost funds in all but one category.

Most Common Investor Mistake

Most investors underestimate the pernicious impact of fees on their wealth.

Mutual fund fees are not flat but rather based on a percentage of your assets. The more your wealth grows, either because you are investing more money into the fund or the stock market goes up, the more you pay in fees.

That means less of your money gets reinvested and compounded. Over time the fees add up considerably.

(NOTE: Wondering if you own high fee mutual funds? Try YourCapital, and discover if cheaper alternatives exist.)

Unwelcome Tax Distributions

Apart from fees, mutual funds are also tax inefficient. This is because you can be hit with capital gains even if you just invested in the fund.

Why is that, you ask?

Portfolio managers buy and sell shares all throughout the year. This activity is represented by the “turnover” metric.

So for the mutual fund GFACX, you can view the “turnover” metric for the fund from the Morningstar summary.

GFACX Mutual Fund Performance

GFACX has turnover of 31% which is very low. Generally mutual funds can have turnover of 100% or more.

This means portfolio managers for GFACX buy or sell 31% of fund securities during the year.

The higher the turnover, the more a fund can generate capital gains as the fund manager buys and sells stocks provided you own the fund in a taxable account.

This brings us to the current rage in investment circles: Exchange Traded Funds (ETFs).

Exchange Traded Funds (ETFs)

ETFs were introduced in the 1990’s.

Unlike mutual funds that are actively managed, ETFs are known as “passive funds”. That’s because ETFs are not managed by a portfolio manager.

Rather, ETFs represent basket of stocks that mirror an index. An index is a collection of stocks and generally each stock in the index is in proportion to its market capitalization.

An ETF that tracks an index mirrors that index.

Which means...an ETF has the same stocks as the index and in the same proportion as the index.

ETF Investor Benefits

Low Fees

For example, SPY is the well known ETF that tracks the S&P 500 index. SPY includes the same 500 stocks as the index and in the same proportion as the index.

Since there is no portfolio manager who actively picks stocks, an ETF is a low fee investment vehicle. The expense ratio of SPY is a mere 0.1% annually.

Trading Like Stocks

And here is another added benefit: you can buy or sell an ETF just like you would a stock.

That’s not the case with mutual funds where the price you pay or get for buy/sell orders is determined at market close when the fund determines its NAV.

But with an ETF, the process of buying or selling can happen instantly while the market is open.

Tax Efficient

...And since an ETF tracks an index which doesn’t change much in its composition, an ETF’s turnover is very low --- meaning you don’t get hit by frequent unwelcome capital gains distributions from the fund.

But you do, however, pay taxes on the gains you incur when you buy an ETF at a low price and sell at a higher one. This is similar to the taxes you would pay if you bought a stock at a low price and later sold it at a higher one.

Low Cost Portfolio Diversification

Another benefit of ETFs is that you can construct a well diversified portfolio for cheap by investing in just a few ETFs.

(NOTE: Want to create a customized low fee ETF portfolio? Use YourCapital to create a customized portfolio of ETFs just for your unique situation.)

Since there are a wide variety of ETFs, it’s incredibly easy to invest in a particular ETF that offers a certain exposure.

For example, if you want exposure to India, you could invest in Blackrock’s iShares India ETF, ticker INDA.

Download Our Best Low Cost ETFs To Create A Diversified Portfolio

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So how should you decide between ETFs and Mutual Funds?

Well, you can create a well diversified portfolio using ETFs or mutual funds.

ETFs are super cheap, have low turnover and more of your money works for you.

Mutual funds are generally expensive unless you can find a manager that consistently outperforms the index, after taking expenses into consideration.

Information Asymmetry Benefits Mutual Fund Mangers

Since most mutual fund managers can’t outperform their benchmarks once fees are taken into account, perhaps it may not make sense to invest in mutual funds except...

when you think the manager can gain informational advantage -- which usually happens when certain markets or segments of the market lack readily available information.

Generally, developed markets like the U.S., are efficient -- which means all public information gets instantly reflected in stock and bond prices.

It’s challenging for mutual fund managers to outperform an efficient market where everyone has easy access to market information.

However, in certain segments of the market, information is not readily available and this lack of readily available information may favor an active manager who performs deep stock specific research to discover undervalued stocks and beat their benchmark.

For example, since few analysts follow small cap stocks, a small cap fund manager can outperform the benchmark after undertaking stock specific research.

Another area where mutual funds may serve you is in emerging markets where information is not readily available to all market participants.

Conclusion

ETFs have gained popularity among investors. You can easily and cheaply use ETFs to create a diversified portfolio. In case you want active exposure, mutual funds are the only way to achieve that.

This is the advice Warren Buffett gave to his heirs:

My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

If ETFs work for Warren Buffett, perhaps they will work for you too.

Please let know if you invest in ETFs.