Reader Question: Should I Invest in Mutual Funds or ETFs?

Mutual Funds

A Frugal Rules reader recently asked a question about mutual funds and exchange traded funds (ETFs), the differences between the two and which would be a better fit for her investment purposes. I love to talk about investing in the stock market and felt there may be more readers out there wanting to increase their knowledge about mutual funds and ETFs. Many individuals (myself included at earlier stages in life) lack knowledge about investment choices and therefore make decisions that are either not planned out or not in line with their needs. When properly understood, mutual funds and ETFs can be valuable tools in an investment portfolio. This post is intended to give a high-level overview of mutual funds and ETFs and is not meant to be exhaustive.

Should I Invest in Mutual Funds or ETFs?

To make it very simple, a mutual fund or an exchange traded fund (ETF) are what we refer to as a basket of securities. Think of it as being able to buy one thing that has many parts as opposed to buying 20 individual stocks. There are thousands of investment options available if you’re looking to invest in the stock market and either of these two vehicles can possibly make it much easier for you as you can have a one-stop shop. This can possibly take some of the fuss out of investing in the stock market as you can invest in a handful of mutual funds or ETFs as opposed to a myriad of stocks and bonds. If you have a 401k, then you’re likely already exposed to either mutual funds or ETFs depending on your plan. What I like about both mutual funds and ETFs is their ability to simplify investing; either is a great way to begin investing in the stock market as it makes investing feel less overwhelming.

Are They Completely Opposite?

We’ve already established that mutual funds and ETFs are baskets of securities. For our purposes, right now, that is where the majority of the similarities end. When deciding between a mutual fund and an exchange traded fund there are three, general, major differences. Those three differences are:

  • Fees
  • How they trade
  • Minimum investments

Because many ETFs track an index like the S&P 500 or the Dow, the fees are generally significantly lower as there is much less active management. Mutual funds however, are generally more actively-managed and therefore have higher fees associated with them. These fees can erode returns over time making it a possible detractor. The next major difference affects how they trade. Mutual funds trade only once at the end of the trading day and the price is generally made public around 5:00 p.m. EST. ETFs however trade like a stock and trade throughout the day, meaning the price fluctuates intra-day as opposed to having to wait until the end of the day. The final major difference is in relation to how much you need to invest in either investment vehicle. If you’re looking to invest in mutual funds, many have a minimum amount you need to start with. This can be as little as $500 or $1,000 and can go up from there. In addition, mutual funds often must be purchased through the given fund family. The nice thing about ETFs is that since they trade on the stock market there is no minimum to start investing in them; you simply buy the amount of shares you can afford. Since they trade like a stock, ETFs can be purchased through almost any brokerage. Finally, ETFs are generally more tax- efficient in how they handle sales.

Make Sure to Look Under the Hood

Is your head swimming yet? Now that you’ve established that you want to invest in either mutual funds or ETFs you need to do your homework to see what suits you best. This is where I will almost always reference my go-to source for mutual funds and ETFs – Morningstar. Morningstar is THE source to go to when you’re considering either of these options. It breaks down exactly how much it’ll cost you to invest in the given fund, which is important to an investor like me who is trying to be frugal and keep my costs down. My favorite section on Morningstar shows the Top 25 holdings of mutual funds and ETFs. The reason why this is vital is that it tells you what they hold in the fund. Don’t just go off the name of the fund to guide you to what you should invest in. For example, you can commonly find Apple or Google being held in a Value Fund when they’re anything but Value and are largely considered a growth stock. The moral is, as with any investment choice, do your homework before you decide which specific mutual fund or ETF you invest in.

What’s Your End Goal?

I’ve written about determining what you’re investing in before as well as setting a risk profile and investing in mutual funds or ETFs is no different. Investing in the stock market is best served when you have a long-term approach as opposed to making rash and emotional decisions. With that in mind, investing in an index fund will suit most investors. As opposed to a fund that picks specific stocks or bonds based off their given ideals, an index fund seeks to mimic the movements of a specific index and thus has lower fees and generally outperforms actively managed mutual funds over the long- term. Most times, but not always, an index fund will be in the form of an ETF and will enjoy lower fees and thus less erosion, in general, over the life of the investment. To make things better for you as the investor, many online brokerages offer a selection of ETFs that you can buy commission-free which is generally not something found with many mutual funds. Like I said previously, when you’re making your investment decisions make sure to do your homework before you invest in the stock market.

 

What’s your take on mutual funds? Do you invest in them or do you look for less actively-managed index funds? If you have any questions on investing, feel free to shoot me an email and I’ll do my best to help you.

 

Photo courtesy of: Paul Pasieczny

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I'm the founder of Frugal Rules, a Dad, husband and veteran of the financial services industry. I'm passionate about helping people learn from my mistakes so that they can enjoy the freedom that comes from living frugally. You can connect via Twitter / Facebook.

66 comments on “Reader Question: Should I Invest in Mutual Funds or ETFs?

  1. I honestly haven’t looked into this too much, but I have my 401k invested in a few different mutual funds (each with various levels of supposed “risk”). I have invested in an ETF in the past and got burned, but that was more a timing issue – though it did leave a sour taste in my mouth! I like the idea of ETFs that they are not actively managed so you don’t have the fees of mutual funds, but some mutual funds do a great job of keeping the fees down. I guess it’s really up to the investor!
    DC @ Young Adult Money recently posted..5 Lessons Learned from FreelancingMy Profile

    • It really is up to the investor in my opinion. It really comes down to looking under the hood and seeing what they’re made up of before making an informed decision.

  2. I generally prefer “no load” ETF and mutual funds. These are funds that normally track the index and aren’t actively managed, so your expense ratios are normally lower.

    I may also suggest to your reader that she consider direct investment in dividend stocks as a good way to have direct exposure to a rising dividend income stream. If they are focussed on the dividend stream these stocks produce, it will help to avoid focussing on changes and swings in the stock price. There are a lot of well known stocks that produce good cash flow that she could consider like Mcdonalds, Pepsi, Coke, Procter & Gamble etc. It will lead to good passive income over time.
    Integrator recently posted..Can a huge dividend yield make up for lower dividend growth?My Profile

    • I am the same way in regards to preferring no load funds. There’s no sense in paying useless fees.

      Going into individual stocks, especially dividend payers, can be a good strategy. However, for many investors just starting out they have no clue as to where to start and are nervous about getting into individual stocks. For someone in that case I would recommend a good, low fee index fund so they can keep up with the indices are doing.

      Thanks for stopping by!

    • I am the same way Joe, if I can buy something with no commission then it’s generally a great deal. There are a few good fund managers out there, knowing which ones to go after are key.

    • Interesting, I actually havent seen an ETF without a commission fee, maybe I haven’t looked hard enough (honestly, that was never a search criteria).

      You said you found some managed funds that have a solid team in place with a great track record, care to share a fund or two? I strongly believe in the team over past earnings because the past is not necessarily an indication of the future and it is possible for “luck” to play into things, especially in the market.
      Listen Money Matters recently posted..Plug Your Spending LeaksMy Profile

  3. I’m not a fan of mutual funds. I think they’re designed to make those on the financial services sector rich, not you. The fees are devastating to your returns over time. Sure it’s easy to rationalize 2-3% because it sounds like a small amount. But compounded over a 20-40 year saving term and you’re talking some SERIOUS dough. Also there is a human element of mutual funds that I don’t like. After reading One up on Wall Street by Peter Lynch I was exposed to how mutual fund managers are human, and sometimes make financial moves out of self preservation rather than what is best for the fund. The example that comes to mind is that managers have been known to sell all of their poor performers at once so they only have to have one really bad report rather then a couple poor reports. ETF’s are the better choice in my book.
    Mandy @MoneyMasterMom recently posted..How do you Manage Stress?My Profile

  4. With the increase in popularity of the ETFs they do have more specific industry-related ETFs instead of ones that simply track the major indexes. Saying that, I do like ETFs but I analyze performance history as well as their fees. You’re right on about the long-term mentality though, so once I make a decision it’s nothing something I flip-flop on.
    Jason recently posted..Recipe: Lemon and Blueberry MuffinsMy Profile

    • Great point Jason! I have a few specific industry ETF’s myself. You have to watch those ETF fees like you said because not all of them are as low fee as one might think.

  5. I have both. In the end it really is just a matter of taste (and barriers to entry). You will almost always be hit with a transaction cost to invest in an ETF, while many mutual funds there is no upfront cost to invest. However, some mutual funds (i.e. Vanguard) have minimums that can be hard for some people to meet ($3k, $10K, $50K etc). Of course you can avoid the investment fee on ETFs by choosing certain brokerage firms.

    Example: I currently have a Vanguard S&P index fund and a bond fund, but I also have a brokerage account there from a 401k rollover where I invested in 4 ETFs. Since I am with Vanguard and invested in Vanguard ETFs there was no transaction costs. I believe the same hold true for Schwab and their ETFs and Fidelity and their ETFs.

    • I think it does come down to taste Brian, as well as what’s best for your portfolio & situation. There are still some front-load funds still out there, which is why I always encourage investors to take a look at whatever they’re investing in to make sure they understand what they’re putting their money in and that it meets their goals. Thanks for stopping by!

  6. Thanks for the simple explanation. We own both mutual funds and ETFs, but I tend to favor ETFs because of the lower fees and intra-day trading flexibility. When you sell or buy a mutual fund, you don’t know the exact transaction price when you place the order, which seems a bit weird. True, the share price generally doesn’t change a lot from the previous close, but still… .
    Kurt @ Money Counselor recently posted..Free Tax Prep HelpMy Profile

    • Thanks Kurt! I like the intra-day flexibility as well. I like being able to have a better gauge on what I’ll be receiving as opposed to just throw darts in the dark. You could have another Flash Crash blip and lose a sizable chunk after placing a mutual fund order.

    • Fees really is the name of the game when it comes down to the two. Even better when done in IRA’s as you don’t want those fees impacting retirement savings.

    • I’ll be interested to see when/if E-Trade starts offering some ETFs at no commission. A lot of their competitors already are. Awesome you’re able to take advantage of some no-load, no-transaction fee funds.

        • $35 for a stock purchase…Ouch! There are a few good options out there. If you’re looking for just basic stocks, mutual funds and etfs then you could go with a number of places. I think if you went with Scottrade, Vanguard, Fidelity or Schwab you’ll do just fine. Most of them are under $10 and have good offerings & tools.

          I personally have an account an account at Scottrade & Options House. I like ST because it’s a flat $7/stock and have reasonable rates on mutual funds. If you do switch, beware of the fees. Not all brokerages offer a flat commission, which really is best as you do not want your money being eaten up by fees.

  7. John, I like to invest in Index funds and have since 2007 because of their no to low fees. Morningstar is also one of my favorite sites to look at. I agree that it’s important for us to know how to invest our money. Many rely on their employers brokerage firm for their 401k or IRA. But even these are invested into Index Funds, Mutual Funds and ETFs so it’s important to know more than just clicking through the GUI. Great post!
    John recently posted..Mahatma Gandhi | Fearless Peace in the Face of ViolenceMy Profile

    • Index funds are quite nice and they can take a lot of the guess work out of investing, especially if you do not want to spend much time analyzing data. I love Morningstar as well, definitely a good resource to use.

  8. The mutual fund industry has been abusing customers for years! (At least in Canada). ETFs are pretty much the death knell for the high-fees we have been subject to.

    There are over 3300 mutual funds in Canada and I would be comfortable owning 3-4 of them. The rest are just “products” designed to keep financial service employees busy.

    ETFs are FAR better from my perspective.

    Full disclosure: I do not own ANY mutual funds. I own a couple ETFs. The rest of my holdings are my own stock picks, as well as some option (derivative) contracts.
    thestarvingartistcanada recently posted..FOOD: pizza sauceMy Profile

    • Sorry to hear that about mutual funds in Canada. I am not going to pretend to know anything about Canadian mutual funds.

      Here in the States, there definitely are some funds that are bloated with fees that I would advise against. However, there are a good number of funds that I’d have no problem recommending to people because of how they’re run. In the end you have to look at fees and performance to make sure whatever product you go into lines up with your goals.

      Thanks for stopping by!

    • You really can’t go very wrong with investing in index funds. I don’t know that I’d say that mutual funds are becoming like a dinosaur, but they do definitely have to position themselves well against the growing ETF market.

    • I generally am as well, though I do hold a pretty decent mutual fund as well. I know there are some brokerages out there like that, I am at one of them now and really would like them to offer DRIP as I really like the ETFs I am in there.

    • No problem Thad. I am in both as well as it depends on both fees and performance for me. Great point on the risk profile, I actually did a post on that a few months back.

  9. Thanks for the explanation John. We met with our advisor recently and frankly even though some people don’t think it’s the best route it’s the better route when you don’t know what you are doing. The last thing someone needs to do is jump in head first into investing because someone tells them that advisors cost a fortune and mutual funds will gobble all your $$$ etc. I like to base our decisions on what’s right for us and through research. I’m still learning so I won’t pretend I know a thing about investing but I would like to learn more about ETF’s and brokerage fees etc. After 25 years our advisor who has some pretty big clients in our area says that he’s still learning something new everyday and has yet to met someone who knows it all. I enjoy reading posts like this with simple explanations. Cheers mate. Mr.CBB
    Canadianbudgetbinder recently posted..A Personal Story:Chores and Money Lessons Growing UpMy Profile

    • Not a problem Mr. CBB! It really does come down to education in order to find what fits your specific situation. There is no “one size fits all” approach to investing, which is why there are so many investment vehicles to choose from. You have to go with what’s right for you and what helps you sleep at night.

  10. Unfortunately all mutual funds and ETFs are not alike. I personally don’t recommend investing in either however for the individual or family with little investing experience this is the most practical avenue of approach. I agree with your assessment to analyze the fee structure and the holdings of each fund & ETF
    Brick By Brick Investing | Marvin recently posted..Food InsuranceMy Profile

    • You’re right on Marvin! For those that have little time/no experience they can be a great tool…as long as the fees/performance are where they need to be.

    • They are pretty nice, though I am going to reserve my feelings on TD as they would not be good on a family friendly site. That said, any time I can buy something commission free then I am usually down for that!

    • That’s interesting. I never knew that. Thankfully there are some here in the States that we can choose from that have fairly low fees. If I was in your case I can see why ETFs would be the hands down winner.

    • I have been in mutual funds for some time as well Steven, though I am in a couple of ETFs. You have to go with what works for you and, in the end, slow and steady wins the race.

  11. I rely on a small local financial advisor firm to manage my retirement nestegg. Now as I am approaching age 65 for some reason he wants me to switch from Mutuals to ETFs plus charge me 0.2% more per year than before. With ETFs it seems I must now trust my advisor’s judgement even more to make sure that the ETFs he selects won’t close, won’t incur an unforeseen capital gain, plus I’ve read that although there are 1,300 products out there, but only about 25 of those account for nearly half of total assets. “Close to half of the funds now trading have less than $25 million in AUM–a rule of thumb for the level of assets required to break even. The economics of an industry built around bargain basement expense ratios can be challenging to issuers. It costs money to run an ETF, and a significant portion of the products out there now are losing money”. So it seems for the hands-off investor like me that ETFs require a lot more scrutiny up front and less manipulation of a portfolio over time while mutuals would be the opposite vis a vis the “financial advisors” role?

  12. ETFs, ETFs and more ETFs. I love these things. This coming from a former broker of a discount brokerage firm who dealt with mutual funds almost exclusively. This is something I go into on my site. But I like ETFs because they are easily diversified, especially inside a variety of industries and asset classes. I also like the bearish vehicles that let you short the market without having to pay margin interest (like when short a stock) and high leverage ones that let you put in positions with smaller amounts of cash and enjoy the same type of market return (disclaimer: these are not for the faint of heart). However, mutual funds still have one great benefit for those who hold long term and invest incrementally with dollar cost averaging. They do not have a transaction fee for those small periodic purchases.
    Chad | The Stock Market and I recently posted..Why QE is Important to YouMy Profile

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