Are Mutual Funds Better Than ETF’s? What’s Best for You

Mutual funds and ETF’s… Things that look the same but are actually very different. Both are a mix of diverse assets, both help investors reduce risk through hedging, and both can be potentially high yielding.

The main difference is, the way they are managed. Mutual funds are actively managed, whereas ETF’s are passively managed, but we’ll look into that later on. But this does not make them better, actually because they are actively managed, they tend to cost more to be involved in the fund.

Mutual funds and ETF’s follow well known indexes such as the S&P 500, or the industry indexes set by Barclays or Bloomberg. Choosing the right fund or ETF to fit your goals is important, however you can spread your portfolio across more than one type of fund, and more than one index.

Even though both fund types offer investors the pooled fund concept, and invest across hundreds of stocks and bonds. You need to assess the differences between the investments to make sure your money is safe.

What is a Mutual Fund?

In 1924 the mutual fund was born, since then mutual funds have been providing investors an extensive selection of pooled fund offerings. While some mutual funds are passively managed, most are actively managed which investors look at fondly as this is the best way to build an optimal portfolio.

Rather than following one specific index, mutual funds are more diverse hence less risky. This can also lead to higher gains in a broad bull market. The only downside to this type of active trading is, the expenses an investor incurs to be a part of the fund.

Some mutual funds have strict investment requirements, such as:

  • Minimum initial deposits, some of which are over $1,000.
  • Minimum deposit term, so your money is held for a specific time before you can withdraw.

Finally, unlike most investments, purchases and sales of mutual funds take place directly between the fund and the investor. The sale price of the fund is not determined until the end of the business day, when the Net Asset Value (NAV) is calculated.

The Two Kinds of Mutual Fund

Mutual funds are legally classified as either of these two types:

  • Open-Ended Funds: These are the most common mutual fund you will find. The issue of shares is done directly between investor and fund, and there are no limits to the number of shares that the fund can issue. These funds are required by federal law to provide daily valuations, which is what affects the funds share value.
  • Closed-End Funds: These funds only issue a specific number of shares and do not issue new shares as investor demand grows. Unlike open-ended funds, the funds share value is not determined by the net asset value, it is driven by investor demand.

Penny for Thought: Before diving into investments in mutual funds, it is important to factor in the different fee structures & tax implications of both fund types.

What is an ETF?

The first ETF was introduced in 1993, this innovative idea tracked the S&P 500. Now there are more than 3,500 ETF’s worldwide.

Regulations primarily require ETF’s to be passively managed with stocks that track certain indexes. However in 2008, the Securities and Exchange Commission (SEC) streamlined the approval process for ETF’s, and now the funds can be actively managed.

ETF’s are generally used by investors who want to gain exposure to wide markets or industries, while keeping the benefit of diversity across their portfolios. Smart Beta funds have become very popular in current years, some of which have grown over 20% annually for the last 5 years.

Most ETF’s on the market are traded as regular stocks, whereby, the profitability of the fund determines the share price.

The Three Kinds of ETF

The three legal classifications for ETF’s are as follows:

  • Exchange-Traded Open-End Index Mutual Fund: Registered under the SEC’s Investment Company Act of 1940, this fund reinvests dividend payments on the day of receipt and then are paid to shareholders in cash every quarter. Securities lending and derivatives may be used in this type of fund.
  • Exchange-Traded Unit Investment Trust (UIT): These funds attempt to fully replicate their specific indexes, they have a 25% limit on single issue investments, and they set additional weighted limits for diversified and non-diversified funds. Cash dividends are paid to shareholders, however the dividends are not automatically reinvested.
  • Exchange-Traded Grantor Trust: The brother to the closed-ended mutual fund, the main difference is, the investor own the underlying shares in the companies the ETF is invested in. This means investors in the fund hold all the rights of shareholders in the companies, such as voting rights. Dividends are paid directly to investors, but you must trade in 100-share lots.

The tax rules surrounding ETF’s are complicated and I would check what implications you are putting yourself under before investing.

Mutual Funds vs ETF 900x900

The Biggest Differences Between Mutual Funds & ETF’s

ETFMutual FundHow This Effects Your Investment
How are they Managed?Passively managed to automatically follow a pre-selected index such as the S&P 500.Actively managed by professional firms who attempt to beat the market or industry they follow.In the short term, actively managed mutual funds perform better, however over long periods of time ETF’s are better as it is unlikely to beat the market every year.
Cost of Investing (percentage of investment amount)Expense ratios ranging from 0.03% to 0.15%.Expense ratios ranging from 0.67% to over 1%. (Early withdrawal from the fund might lead to a penalty)Yes, mutual funds are more expensive, but depending on which fund performs better determines your overall profit.
How are they Traded?They track major indexes, and are traded as regular stocks on the market. Share price is determined by investor demand.Bought directly from the fund company, or through a broker. Share price is determined by the net asset value in the fund.By trading ETF’s like stocks, you might incur a brokerage commission unless you use one of my recommended brokers. These commissions are avoided with mutual funds.
How are they Taxed?Some ETF gains can be treated as regular income. Gains made in a tax-advantaged account such as a 401(K) or Roth IRA are tax deferred.Mutual fund profits tend to incur higher capital gains tax. This is down to them being actively managed, hence assets are bought and sold more frequently.This is another reason long term investors prefer ETF’s, the tax savings that can be made in tax deferred accounts are great. For mutual funds, any capital gains accumulated are passed onto the investor.
What is the Minimum InvestmentAs long as you can afford the share price you can buy into an ETF, you can use brokers such as eToro or M1 Finance for fractional shares.Some funds have minimum initial investments, of those that do, it could be more than $1,000This massively impacts the amount of people that can invest in mutual funds, however if you can use mutual funds as retirement savings which you will likely add a lot of money too.

What Investing in a Mutual Fund is Like

When you invest in a mutual fund, the transaction is with the company that offers the service, like Vanguard or BlackRocks. You can invest directly, or through a brokerage firm.

The purchase of fund shares is completed at the net asset value of the fund based on its price when the market closes. When you sell your shares, the same process is used. However, some mutual funds assess penalties for selling early, typically within 90 days of purchase. This penalty is usually a percentage of the share value you wish to sell.

As mentioned before mutual funds tend to follow indexes, but they are actively managed, so the fund managers pick a variety of holdings to try and beat the chosen index that they are mimicking.

This part is important to understand the daily working of a mutual fund. If more money goes into the fund than out of the fund in a day, the managers have to fix the imbalance by putting that extra cash to work in the market. However if the fund has more money leaving, they have to sell holdings to support the cash balance. This is how share price is determined.

My 3 Favourite Mutual Funds

#1. Fidelity Contrafund (FCNTX)

  • 1 Year Return: 25.23%
  • 10 Year Average Annual Growth: 15.76% per year
  • Expense Ratio: 0.85%
  • Risk Level: 3 out of 5

This mutual fund is heavily based around American tech stocks such as Amazon, Apple, Microsoft and Netflix. Meaning it has seen massive growth over the last 20 years, and there is a lot more to come.

The funds managers outline the objectives as: ‘Investing in securities of companies whose value FMR believes is not fully recognised by the public’. This shows great confidence in future investments as long term growth companies.

#2. American Funds Growth Fund of America (AGTHX)

  • 1 Year Return: 28.12%
  • 10 Year Average Annual Growth: 14.62% per year
  • Expense Ratio: 0.65%
  • Risk Level: 2 out of 5

Focusing on large growth stocks in the U.S. this fund can yield massive returns. With 83.7% of its holdings in U.S. companies, it doesn’t offer that much geographical diversity, however it hasn’t been a bad thing yet.

Again this fund is massively invested in tech companies, making it another quick growing fund.

#3. Vanguard 500 Index Fund (VFINX)

  • 1 Year Return: 11.81%
  • 10 Year Average Annual Growth: 13.68% per year
  • Expense Ratio: 0.14%
  • Risk Level: 4 out of 5

This is the lowest costing fund that gives full exposure across the full U.S. marketplace. Holding not only major tech companies, this fund diversifies with healthcare, bio-tech, utilities, and consumer stocks.

The only downside with investing in a fund this broad is the lower yield, you will have higher gains investing in industry specific funds. However you expose yourself to higher levels of volatility.

What Investing in an ETF is Like

Exchange traded funds, as the name suggests, are traded on major exchanges just like regular stocks. Rather than buying into the fund, like you would with a mutual fund, you purchase shares which you trade with other investors, not the fund manager.

You can buy and sell at anytime during the day period, there is no limit or minimum buy, and there is no minimum holding period.

Now… ETF’s still charge fees to be involved, but because they are passively managed they are massively cheaper than mutual funds. If you traded directly with the fund the fees will be deducted from your share value, however if you purchase through a broker, the fees can be taken either from your share value, or dividend payment.

Other than the fees, the way you invest in ETF’s is no different than investing in company stock, it’s just a little easier.

My 3 Favourite ETF’s

#1. Vanguard S&P 500 ETF (VOO)

  • 1 Year Return: 11.87%
  • 10 Year Average Annual Growth: 13.84% per year
  • Expense Ratio: 0.03%
  • Risk Level: 4 out of 5

This ETF follows the most commonly known index there is, the S&P 500. By consistently matching the returns of the S&P 500, Vanguard have been able to boost growth of this ETF by over 10% each year in the last decade.

With large companies there is still risk to be considered. Not all companies are going to perform well, and some might crash and burn, but for the most part… As long as the American economy is stable, the top 500 companies will continue to perform well.

#2. Fidelity ZERO Total Market ETF (FZROX)

  • 1 Year Return: 10.95%
  • Lifetime Average Annual Growth: 8.70% per year
  • Expense Ratio: 0%
  • Risk Level: 3 out of 5

Spanning the entire U.S. market, this fund offers investors great diversity for a low cost. This ETF does not charge any fees, and has average yearly growth of just over 8%, making it one of the few free funds you can invest in.

The Fidelity fund managers try to keep 80% of the ETF’s holdings in common stocks, exposing it to high amounts of volatility, hence higher risk. But the fund managers at Geode Capital Management are confident they can uphold these gains year on year.

#3. Schwab U.S. Dividend Equity ETF (SCHD)

  • 1 Year Return: 4.70%
  • 10 Year Average Annual Growth: 12.55% per year
  • Expense Ratio: 0.06%
  • Risk Level: 2 out of 5

This fund specifies that it holds dividend paying stocks from the U.S. making it a great pick for income investors. The quarterly dividend payment from this ETF is currently $0.44, at a dividend yield of 3.54%.

Because the fund invests in large cap dividend stocks, most of these being dividend aristocrats, it lowers the risk of investing as the track record for these companies is fantastic. The ETF tracks the Dow Jones U.S. Dividend 100 Index.

5 Reasons to Choose Mutual Funds over ETF’s

In the following sections you should look at these reasons and think which apply to your life, or your investments. Do you need more diversity in your portfolio? Are you saving for retirement? Or are you looking for a safe way to grow your money?

Think about what you want to achieve and go from there.

  1. Wider Variety: The number one advantage to mutual funds is the variety of options on the market. There are an unlimited amount of possibilities that aren’t available with ETF’s, such as specific risk levels, asset types, and investment strategies.
  2. Active Management without Leverage Risk: Actively managed ETF’s are known as leveraged ETF’s which means, you borrow money from the fund to bet on the market. This can be very dangerous and you can lose money you weren’t even investing. Mutual funds, although they might have minimum deposit limits, don’t offer leverage, meaning you will never receive a margin call.
  3. Quality Customer Service: With ETF’s you purchase shares and might be able to contact investor relations, but they never seem to know the answer to your questions. With mutual funds, because you are invested in the fund rather than a shareholder, fund managers are at your disposal 24/7. Because the last thing they want is for you to withdraw your money.
  4. Automatic Investment Options: With automatic investment options, you can reinvest your dividend payment back into your mutual fund allowing you to take advantage of compound interest. With ETF’s you would normally have to do this manually. Also, because ETF’s are sold in shares, you would have to wait until you received enough dividend to purchase more. Unless you use M1 Finance!
  5. No Brokerage Fees: Because you buy into a mutual fund directly from the fund manager, you do not pay any brokerage fees & commissions when you deposit or withdraw money. There are certain online brokers like M1 Finance that offer 0% commission trading for ETF’s, but they’re not common.

5 Reasons to Choose ETF’s over Mutual Funds

These are the reasons I prefer ETF’s over mutual funds, but as I mentioned before, you want to pick something that is right for you.

  1. Tax Benefits: Due to ETF’s construction, you only incur capital gains tax when you sell your shares. With mutual funds, you own part of the shares held in the fund, meaning you will incur capital gains tax whenever the fund manager sells a stock. You do not incur the funds capital gain tax bill with ETF’s.
  2. They are Very Simple: Buying & selling shares in an ETF is just as easy as investing in a company, you can go direct to the fund or through a brokerage account. Unlike mutual funds which need to be done directly with the fund manager, and have certain criteria you need to meet.
  3. Investing Flexibility: With new ETF’s coming on the market every year, investors can choose how they make money through ETF’s. Some of options include, Equity ETF’s, Bond ETF’s, Currency ETF’s, Commodity ETF’s, and Specialty ETF’s. A few investors like to bet on the market going down, that is where inverse ETF’s come into play.
  4. Easy ETF Transfer: If an investor wants to transfer a portfolio to a different firm, complications can arise with mutual funds. Sometimes investors will need to make unwanted trades to release money to transfer. With ETF’s you original investment can be transferred as they are considered portable funds.
  5. Added Due-Diligence: With any investment, you want as much knowledge as possible. ETF’s, because they trade like companies offer the most information about the fund than any other likewise product out there. For mutual funds, you usually have to speak to a financial advisor, or gather information directly from the fund, which can be misleading. Third party analysts provide in depth information about major ETF’s.

I hope this section has helped you decide which investment you want to make.

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Chris Race

I am an accountant from the U.K. specialising in Management Accounting, Personal & Business Tax, Financial Analysis, and Wealth Management. My passion for learning is what lead me to creating this blog. Stock market investing has always been a interest of mine, and since I was 18 years old... This interest has become a source of income for me and my family.

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