Mutual funds and ETFs are two of the most commonly used investment vehicles today. And both are beneficial to the everyday investor that doesn’t have time to vet and research every company.
How are they different, how are they similar, and which one is better?
Similarities in investments
A mutual fund is an investment vehicle that has a variety of different investment options and characteristics.
There’s a wide variety of funds available:
- Index funds - Follows a specific index, like the S&P 500 or Barclays Aggregate Bond Index
- Sector-specific funds - Exactly what you think. These funds invest in specific sectors, like utilities, consumer discretionary, or technology, to name a few.
- Equity funds - Invest exclusively in stocks. These can be in companies based in the United States or based abroad
- Bond funds - Invest exclusively in bonds. Like stocks, can be in the U.S. or in other countries. There are also municipal bonds, which invest in municipalities. These funds have a distinct advantage, though. The interest and dividends paid by the fund aren’t taxed at the federal level.
- Money market funds - These funds are considered extremely safe because they invest in short-term debt instruments, like US Treasury bills and commercial paper. This safety comes at a cost, however, because these funds pay very little interest.
- International funds - Invest in companies based all around the world, including the US.
- International ex-US funds - Invests in companies based in any country, excluding the US.
- Balanced funds - Invests in stocks and bonds. These funds typically keep an allocation around 50/50 with some deviation depending on the market environment.
There are also funds that utilize different investment strategies:
- Growth funds - These funds typically invest in high-growth sectors and industries. Most of them will have a significant portion of their portfolio in technology and/or consumer discretionary. Significant is anything over 20%.
- Value funds - Seek out companies that are undervalued or have fallen out of favor. They also, typically, invest in stable/steady industries, like utilities and consumer staples.
- Momentum funds - All momentum funds have their own formula to determine momentum, but the nuts and bolts of it come down to companies/industries that have seen a sharp increase that’s anticipated to continue.
- Long only - Invest in companies they think will increase in price over time. How long they’re invested in a company varies.
- Short - Invests in companies they think will decrease in price over time. Typically hold onto securities for a short amount of time.
- Long-short - Utilize both strategies.
- Leveraged - These funds borrow money to increase their investment exposure. They are investing more than 100% of their capital.
Not going to lie, I’d stay away from the last three. There’s too much risk associated with shorting and leverage.
What I think
I’ll be honest with you. I prefer ETFs over mutual funds. They’re better in almost every way. The only thing that mutual funds had on ETFs was active management, but now there are actively managed ETFs.
ETFs trade like a stock. You can buy and sell throughout the day. With mutual funds, trades are only made at the end of the day, regardless of what time you put the order in.
ETFs minimize tax liability. With mutual funds, as the manager buys and sells securities, they (if they’re good) will incur capital gains, and they pass those down to the shareholders. ETFs don’t do that. Similarly, the fund manager is sometimes forced to sell positions to meet redemption orders.
A redemption is when a shareholder of a particular fund sells their holdings and wants their “money back”. This can cause even more capital gains.
ETFs have lower (for the most part) expense ratios. An expense ratio is what it costs to run the fund, and includes administration costs, transaction fees, and salaries.
There’s something else to be aware of with mutual funds. They carry loads and added fees. A load is the sales charge and it’s normally expressed as a percentage of investment. There are different sales charges for different fund share classes.
- Class A - is an upfront sales charge with a range of 5.75% to 0%, depending on the size of the investment. A shares are meant to be held, long-term.
- Class B - is a back-end sales charge and it’s assessed if you sell before a certain period of time.
- Class C - is an ongoing charge and is usually 1% of assets invested. C shares are meant to be held, short-term.
Once upon a time, mutual funds were awesome and for certain people, they might still be the best option. However, the ETF can do everything a mutual fund does and it can do it better.
Especially, with the race to zero (fees), investors can only benefit from these improvements.