[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
- 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 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)
- 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.
Curious why you don’t say anything about the return of different mutual funds and ETFs and instead choose to focus on just the cost side. You would agree that not all ETFs & Mutual Funds have the same performance over the long-term, right, depending on if they’re just based on an exchange, a region, or a sector, etc.? So why would I choose to invest in something with a lower average return (say 7%) with lower fees (say 0.10%) vs. something with a higher long-term average return (say 9%) but with higher fees (0.35%)? Option B is obviously better.
Not picking on you. Always a question I’ve wondered about in the passive investing world. I feel like a lot of the advice gets so focused on costs and nobody talks about returns. Can I not do better with my money than just buying an S&P ETF if I know more about particular sectors, cap groups, regions, etc.?
I’d say because the cost aspect is what separates them, all things held equal – if you want to invest in a particular sector or region, you could do so with either an ETF or a mutual fund. This is just a general education on the differences between two similar investment vehicles; what you’re talking about becomes investment advice, needing to factor in risk tolerance, time horizon, investment purpose, etc.
The Money Wizard says
Ben hit the nail on the head.
As far as those other more complicated factors, I’ll take a stab the best I can in a short comment.
The problem is historical returns aren’t indicative of future performance, and often, the opposite is true. So just looking at a specific sector and seeing it’s returned well in the past doesn’t mean it’s going to outperform everything else moving forward, and it may actually have a better chance of underperforming moving forward. At least statistically.
The other point to consider is a basic principle of finance 101 – there’s no such thing as increased returns without increased risk. So an ETF based on the wild west style marijuana industry, for example, might produce higher returns, but it also has a much higher chance of losing you tons of money.
Then there’s ETF picking… You might personally know more about an industry due to specific expertise or a (legal, I hope) insider tip. Otherwise you’re just speculating, which puts you in the same camp as the 99% of stock pickers failing to consistently beat the S&P 500’s 7% return, or the 85% of professionals whose funds under perform the market.
I’m not saying the S&P 500 is the only ETF you should ever invest in. But I am saying to choose ETFs based on portfolio allocation, and not just the hope of juicy returns. I’ve got a post about portfolio allocation coming next month.
[email protected] says
I always wondered why once you hit the $10k mark in Vanguard, the ratio was lowered. Great explanation and definitely cleared some things up for me.
The Money Wizard says
Great post MMW! I think I’ve read one of yours that was almost exactly like this one from a year or two ago when I first got started with investing. My strategy as of now is max out Roth, max out 401k, if anything left, put it in an online savings account for a down payment on a house (Ally at 1.8% right now is not very shabby for easy/immediate access). Anyway, both portfolios are with Vanguard, and I choose all ETFs in my Roth until I reach the $10k limit so I can move them to mutual funds and get that super-low 0.04% fee. I think it’s 0.1% if you have the minimum $3,000 for mutual funds, but I’ve learned and incorporated frugality from the best one out there and I thank you for that! Also worth noting that you didn’t mention in your post is that ETFs at vanguard vs mutual funds at vanguard have the exact price after 4pm every day.
The Money Wizard says
Ah yes, you probably read the original on InvestmentZen. I started getting a lot of Vanguard vs. ETF questions in my inbox, so I figured I’d republish this one for people who never venture to my writings out the mymoneywizard.com walls.
Congrats on improving your situation!
And here you come with the best comparison of ETFs and Mutual Funds I’ve ever seen (and I regularly read Vanguard’s own material on the matter). Saving this for when someone asks me about the difference. Absolutely awesome. Personally I fit the “People who should invest in Mutual Funds” description to a tee and that’s why they have all my money 🙂 .
The Money Wizard says
Awesome! Glad you liked it, and thanks for the high praise.
I thought Vanguard ETF’s had no transaction costs for Vanguard customers. Is that not the case anymore?
The Money Wizard says
You are correct.
I should have probably included that note, but this was meant as more of a general comparison between ETFs and Mutual Funds and not Vanguard specific. Just another reason why Vanguard is awesome!
I use both instruments. The difference for me is that i buy-&-hold mutual funds and I use ETF’s as a trading vehicle.
I like ETF’s because they trade like a stock, meaning you can place limit orders and, (hopefully) catch the fund when it takes a turn downward turn on a buy order or up on a sell order. I don’t know that mutual funds allow this. Do I have that right?