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.
What are the key advantages of an ETF over a mutual fund? ›
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
What is the biggest difference between ETF and mutual fund? ›
How are ETFs and mutual funds different? How are they managed? While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed.
What is the main advantage of mutual funds? ›
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 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.
Why might an investor not want to use a mutual fund? ›
However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end, and back-end load charges, lack of control over investment decisions, and diluted returns.
Why don't I invest in ETFs? ›
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.
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.
Is S&P 500 a mutual fund or ETF? ›
An index fund is a type of mutual fund that tracks a particular market index: the S&P 500, Russell 2000, or MSCI EAFE (hence the name). Because there's no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds.
What are some arguments for why a mutual fund is better than an ETF? ›
As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high. Mutual funds, by contrast, always trade without any bid-ask spreads.
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 is the main advantage of a mutual fund over a stock? ›
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 more tax efficient than mutual funds? ›
Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
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.
