Mutual funds and exchange traded funds (ETFs) do pretty much the same thing, which is allow an investor, with a single purchase, to own a diverse pool of assets – usually stocks or bonds, but also sometimes commodities, currencies, futures, bank loans or other financial exotics.
Since they mostly do the same thing, the most interesting question is usually not “mutual fund vs. ETF?” but rather a question about “asset allocation” – that is, what things you actually own within an ETF or mutual fund.
I wrote a few months ago what I consider to be the final word on the asset allocation question. To repeat:
“You should invest via dollar-cost averaging in no-load, low-cost, diversified, 100 percent equity index mutual funds, and never sell. Ninety-five percent of you should do that, 95 percent of the time, with 95 percent of your investible assets.”
What about ETFs?
You probably noticed I said ‘mutual funds,’ not ETFs. Well, 95% of the time you could substitute ETF for mutual fund and get the same result.
The rest of this column is about the 5% of the time when it makes a difference. The factors that make up that 5% include timing, minimum investment amounts, costs, liquidity, and availability of assets.
I like to call ETFs “mutual funds with ADHD” because you can trade them at any time of the day that markets are open, including multiple times a day if you like. This contrasts with mutual funds, which you can only buy or sell based on the end-of-day price, after the 4pm market close.
This feature of ETFs is not an advantage from my perspective. Since the right holding period for investing in stock markets is somewhere between 5 years and forever, the ability to trade in the middle of any day, for an individual, should be wholly irrelevant.
Some mutual funds and some mutual fund companies require a minimum investment such as $10,000, or $5,000, or $2,500. Or, different prices apply for different minimum investments. ETFs, by contrast, often can be purchased for as little as $100.
As a result, for newbie investors with their first $500 or $1000, ETFs can be the first step needed to get ‘in the market.’ Which is nice.
ETFs and mutual funds come in both high cost and low cost varieties. For myself, I almost always seek out the low cost flavor, which tend to be in ‘passive’ or ‘index’ funds, rather than ‘active’ or ‘managed’ funds.
Vanguard – the giant brokerage and mutual fund company – reports that among ‘active’ strategies the average ETF is cheaper than the average mutual fund. Among ‘passive’ strategies, however, the average mutual fund is cheaper than the average ETF.
The key to understanding your costs, of course, is to go beyond the ‘average,’ and to actually figure out the specific cost of any mutual fund or ETF you’re thinking of buying. Depending on the size of your portfolio and the time you have to invest, minimizing management fees will save you tens to hundreds of thousands of dollars over your lifetime.
So, it’s worth taking those five extra minutes and figuring out the fees, for a return on your time spent of, like, infinity.
Finally, depending on your brokerage company, purchasing some funds and ETF may incur ‘loads’ when you buy, and transactions costs when you buy and sell. Naturally, avoid if possible.
ETFs appear at first to offer better liquidity than mutual funds, because of the moment-to-moment prices for trading ETFs, rather than the once-a-day price of mutual funds. That kind of liquidity advantage, however, should be irrelevant, since your investment holding period ought to be measured in years, not hours or minutes.
In another sense, however, ETFs may in certain cases be less liquid than mutual funds. As you move on the spectrum from plain vanilla to more exotic ETFs, it’s possible that the illiquidity of the underlying assets raises the cost of transacting in ETFs.
During this past August’s market turmoil, for example, traders reported that certain ETFs in relatively illiquid assets such as bank loans or corporate bonds mispriced during the trading day.
As an individual investor, you should assume the ‘mispricing’ will not be in your favor in these situations. Market makers will raise the cost for investors of getting in and out of these illiquid ETFs through a larger wider gap between the price you can buy or sell the ETF, known as the ‘bid-ask spread.’
Availability of assets
Some brokerage or mutual fund companies where you do your investing may have a better inventory of products in ETFs versus mutual funds – or vice versa – making it necessary to buy one rather than the other. Because most of the time mutual funds and ETFs in the same assets do the same things, normally you can substitute one for the other without worry.
As always, the choice of ‘asset allocation’ – what underlying things you’re buying – matters more than the packaging, whether wrapped in an ETF or a mutual fund.
 To give you a benchmark for high or low costs, some active mutual funds and ETFs charge 1.5% fees or more, while some passive mutual funds and ETFs charge 0.15% fees or less. That’s an order of magnitude of ten times the cost between the low and high cost varieties.
 The average index ETF charges a 0.29% management fee, while the average index mutual fund charges a 0.14% fee. So index mutual funds are cheaper, on average, than index ETFs. The average actively managed ETF charged a 0.62% fee, while the average actively managed mutual fund charges 0.80%. So actively managed ETFs are cheaper than actively managed mutual funds, on average. Source: Vanguard webinar on ETFs v. mutual funds.
A version of this appeared in the San Antonio Express News
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