Debates regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs) are common in the investment community. Mutual funds and ETFs have benefits and drawbacks. Though ETFs offer market-based trading and typically lower expense ratios, investors may choose mutual funds over ETFs for several reasons.
Key Takeaways
- Mutual funds are an established investment vehicle, but ETFs have gained popularity.
- Some mutual funds are actively managed and have some risk due to leverage but limit the amount that can be used.
- ETFs are generally less expensive than mutual funds but with less management and reduced services.
Strategy and Risk Tolerance
Mutual funds are available for all different types of investment strategies, risk tolerance levels, and asset types. ETFs can be limiting as they are mostly passively managed indexed funds that invest in the same securities and mirror the chosen index.
Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.
Investing in mutual funds allows investors to choose a product that suits their risk tolerance levels and meets specific investment goals, such as dividend income or retirement planning.
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Active Management Without Leverage Risk
By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate a multiple of an index's returns. While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility.
Mutual funds are strictly limited regarding the amount of leverage they can use. Mutual funds can borrow capital, but they must ensure that they have "an asset coverage of at least 300 percentum," or only one-third of the total value of a fund. Mutual funds offer many combinations of security and risk to investors.
Individuals can choose mutual funds that focus on long-term capital gains that primarily invest in proven growth stocks but also look to benefit from early identification of up-and-coming businesses poised for exponential growth. The tried-and-tested stocks form a solid basis for long-term gains, while investments in newer or undervalued stocks provide the potential for rapid growth in exchange for a certain degree of risk.
Automatic Investment and Customer Service
Mutual funds offer automatic investment plans and ETFs do not. These services facilitate regular contributions and allow investors a consistent way to grow their investments, especially for retirement. The practice of investing a set amount each month allows for dollar-cost averaging, where investors pay less per share over time by purchasing more shares with the same amount of money in months when the share price is low.
Unlike ETFs, mutual funds can be purchased in fractional shares or fixed dollar amounts.
ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be slightly more costly, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer check-writing options and other shareholder services that ETFs don't provide.
Dividend reinvestment plans (DRIPs) take the stress of decision-making by automatically converting dividend distributions into investment growth.
How Are Mutual Funds Priced?
Mutual funds always trade at Net Asset Value (NAV). Mutual fund orders are executed once daily and all investors receive the same price.
Do Mutual Funds Have Minimum Investment Requirements?
Most mutual funds require a minimum initial investment based on a flat dollar amount.
How Are Mutual Fund Investors Taxed?
When a mutual fund sells securities in the fund, it may trigger capital gains for shareholders, even for those with an unrealized loss on the total mutual fund investment. Investors are liable for taxes on the capital gains earned.
The Bottom Line
Both mutual funds and ETFs can be smart investment choices, and many investors may choose both. However, there are some clear reasons why mutual funds may be the better choice for an investor's goals and strategy, such as those that want periodic investment or a wide variety of fund options.
FAQs
Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.
Why do investors prefer mutual funds? ›
Advantages of Mutual Funds. There are several specific reasons investors turn to mutual funds instead of managing their own portfolio directly. The primary reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
What are three disadvantages to owning an ETF over a mutual fund? ›
Disadvantages of ETFs
- Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
- Operating expenses. ...
- Low trading volume. ...
- Tracking errors. ...
- The possibility of less diversification. ...
- Hidden risks. ...
- Lack of liquidity. ...
- Capital gains distributions.
Managed funds are unlisted, but they can also easily be bought and sold on trading platforms such as Vanguard Personal Investor. Unlike ETFs however, the price of a managed fund doesn't change in real-time throughout the day.
Is it better to hold mutual funds or ETFs? ›
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
Is it better to invest in ETF or mutual funds? ›
Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
What is the #1 reason investors prefer mutual funds for investing? ›
Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. Investing with a group offers economies of scale, decreasing your costs. Monthly contributions help your assets grow. Funds are more liquid because they tend to be less volatile.
What is the main difference between ETFs and mutual funds? ›
With a mutual fund, you buy and sell based on dollars, not market price or shares. And you can specify any dollar amount you want—down to the penny or as a nice round figure, like $3,000. With an ETF, you buy and sell based on market price—and you can only trade full shares.
What are the pros and cons of a mutual fund? ›
One selling point is that they allow you to hold a variety of assets in a single fund. They also have the potential for higher-than-average returns. However, some mutual funds have steep fees and initial buy-ins. Your financial situation and investment style will determine if they're right for you.
What is the downside to an ETF? ›
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Commissions and Expenses
Every time you buy or sell a stock, you might pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment's performance.
What happens if an ETF goes bust? ›
Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.
Should I switch my mutual funds to ETFs? ›
If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
Why are ETFs so much cheaper than mutual funds? ›
The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.
What shares does Barefoot investor recommend? ›
Barefoot Investor shares part 1: The Breakfree Portfolio
- Australian Bluechip Shares: STW – 35%
- Australian Small companies: VSO – 15%
- Global Bluechip Shares: IOO – 20%
- Australian Property securities: VAP – 20%
- Australian Fixed interest: VAF – 10%
Mutual funds give you an efficient way to diversify your portfolio, without having to select individual stocks or bonds. They cover most major asset classes and sectors.
Are ETFs and mutual funds risky Why or why not? ›
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
