How To Decide Between An ETF Or Mutual Fund?

[Note: This is a guest post I originally published on InvestmentZen.com, titled How to Decide Between an ETF or Mutual Fund?] 

So you’ve seen the light and you no longer have any Wolf of Wall Street style illusions of grandeur. You’ve decided to avoid becoming one of the 99% of stock traders underperforming the index, and instead you’d like to be the index.

A wise decision. Instead of spending hours and hours analyzing financial statements for the miniscule 1% chance that your bets beat the market, indexing gives you diverse, stable, and relatively reliable market gains from an investment strategy that takes about 5 minutes per month, if you’re slow.

Ah, doesn’t that feel like a weight off your shoulders?

But just as soon as you’ve put that internal struggle with greed in the rearview mirror, you find yourself at yet another fork in the road! Should you invest in a Mutual Fund or an ETF?

Beginning investors often become overwhelmed by this decision. After all, “index funds” are offered as both ETFs and Mutual Funds, and the differences between the two can certainly seem confusing.

Step 1) Understand the Differences Between a Mutual Fund and an ETF

Mutual Fund: the old school index fund. The “mutual” in the name stems from their structure. As an investor with a limited amount of money to invest, buying enough individual shares of different companies to fully diversify can become costly in a hurry. With large companies trading for $100+ per share, imagine how much it would cost to buy 1 share of the approximately 4,000 publicly traded companies on the major US stock exchanges, let alone the thousands more traded internationally.

To solve this dilemma, our investing grandfathers came up with a solution. Investors pooled their money together, which allowed them to invest in more diverse portfolios than otherwise possible, and then mutually split the gains and losses. And that kids, is how mutual funds are born.

At the end of each trading day (4:00 PM ET), the value of the entire fund’s holdings is totaled up and the fund is given a value (divided by its number of shares). This is when investors can purchase or sell more shares.

ETF: stands for Exchange Traded Fund. ETFs function very similarly to mutual funds, in that the funds pool money, then buy a ton of underlying assets for the purposes diversification.

Unlike mutual funds, who only calculate their value once per day, ETFs trade like normal stock. This means ETFs experience price changes all throughout the day and can be purchased at any time.

And that’s it. That’s the only difference between these two indexing options.

However, this one tiny difference does create some practical differences for you, the investor, and one choice could be better than the other depending on your situation. We’ll get into that in a moment.

Step 2) Relax.

Much like choosing your retirement account, the Mutual Fund vs. ETF decision is a lot like deciding between cheesecake or chocolate chip cookies for dessert. Two great options, and both are likely to leave you fat and happy. In the wallet, that is.

Step 3) Find the Right Types of ETFs or Mutual Funds

Perhaps the most important step in the ETF vs Mutual Fund debate is making sure we’re not getting ripped off.

There are many mutual funds and ETFs which are actively managed, and that’s not what we want. Actively managed mutual funds/ETFs constantly make trades attempting to outsmart the market, and at least 85% significantly underperform the index. Just say no.

We also do not want anything with a sales fee, which in the mutual fund world goes by a number of sneaky names such as:

• 12-b1 Fees
• Loads
• Front-end loads
• Back-end loads

Under no circumstances should you invest your money in a fund with any of these fees. Never, ever.

If you do willingly use that computer of yours to invest in a high fee fund, I will come to your house and beat you over the head with your laptop. Fees are that bad.

What we’re looking for in a good mutual fund or ETF is something that’s passively managed and tracking a broad index like the S&P 500, the Dow, or the Total Stock Market.

Overall, we want something with low fees and low turnover, like Vanguard’s Total Stock Market Index Fund or its ETF equivalent, the Vanguard Total Stock Market ETF.

So we know we’re not getting ripped off, but the question remains. Would you be better off investing in the mutual fund or the ETF?

Step 4) The Practical Differences Between ETFs Vs Mutual Funds.

Remember, ETFs trade like stocks while Mutual Funds act like more like a bank account. That one little difference does create some pros and cons for you, the investor:

ETF Pros:

• ETF expense ratios are often lower than mutual funds, especially for smaller investment amounts.
• ETFs usually have lower minimum investment amounts (typically the price of one share).
• Can be bought and sold any time during the day.
• Ability for more complex investing options, like short selling and buying on margin. (Neither are recommended for beginners)

ETF Cons:

• Because ETFs are traded like stocks, each trade is subject to normal brokerage commissions. (Usually $5-10 per trade, depending on your brokerage)
• Buying ETFs are subject to the bid ask spread difference, although for large ETFs this amount will typically only cost you about 1 cent per share purchased.
• No automatic investment options.
• Can only be bought in whole shares. (If you want to invest $80, but shares cost $100, you’ll need to search the couch cushions for an extra $20.)

Mutual Fund Pros:

• No transaction costs, because mutual funds are not bought and sold like stocks, and you don’t need a broker. (You can purchase directly through the mutual fund company, such as Vanguard.)
• Automatic investment options exist.
• Can be purchased in fractional shares. (If you want to invest $80, and shares cost $100, you will be given credit for 0.8 of a share, and returns will be distributed accordingly)

Mutual Fund Cons:

• Minimum investment amount is usually between $1,000 and $10,000.
• Can only be bought and sold once a day.

Mutual Funds vs. ETFs – Final Thoughts

If you’re beginning your investment journey without a whole lot of capital, ETFs are an attractive choice.

For the price of just one share of Vanguard’s Total Stock Market ETF ($119.03 as of this writing) you can invest into one of the most well rounded, diversified index funds, and your only expenses will be the approximately $8 purchase commission and a miniscule 0.05% ongoing expense ratio.

On the other hand, for people who regularly add money to their index funds, that $8 brokerage fee adds up. The ability to purchase additional shares in your mutual fund without paying any transaction fees is a huge benefit, and the ability to automatically invest into your mutual fund and purchase fractional shares makes for a great choice for someone planning on consistent contributions.

Plus, the low fee advantage of ETFs is often short lived. Vanguard, for example, lowers the mutual fund expense ratio to match the corresponding ETF’s expense ratio once your balance accumulates over $10,000.

We’ve thrown around a lot of details in this article, so let’s cheat our way to the finish.

Mutual Funds vs. ETFs – The Cheat Sheet

People who should invest in ETFs:

• You have a very small amount of money to invest, and you don’t plan on reaching the account balance amount to lower the mutual fund’s fees down to its ETF counterpart any time soon.
• You’re an active stock trader and you plan on doing some crazy stuff throughout the day with that ETF of yours.

People who should invest in Mutual Funds:

• You have enough money to invest to ensure you’re getting the lowest available fees.
• You plan on making regular contributions to add to your investment.
• You’d like to set up automatic contributions to your investments in pre-determined amounts.

But above all, maybe the most important consideration is avoiding paralysis by analysis.

No matter which option you choose, you’re making a great investment decision that is likely to significantly outperform these fancy pants, hotshot stock traders. Remember, we’re choosing between cheesecake and chocolate chip cookies here.

Now, go fatten up your wallet.

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