At the heart of the ETF vs mutual funds pros and cons discussion is the fact that ETFs have much lower fees
You might say we specialize in “plain vanilla” stocks, bonds, ETFs—the ordinary kind, in other words, without lots of added features and fees. But even so, investors looking to put their money into investment products need to understand the ETF vs mutual funds pros and cons.
Less likely to harbour hidden risks
“Here’s a good general rule to follow when choosing investments: Simple is better. The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”
Pat McKeough explains why in this special report and recommends 11 ETFs for a stronger portfolio.
ETF vs mutual funds, pros and cons: There are similarities between ETFs and mutual funds, but there are also some big differences.
ETFs are a little like conventional mutual funds, but with two key differences.
First, ETFs trade on a stock exchange throughout the day, much like ordinary stocks. So you can buy them through a broker whenever the stock market is open, and generally you pay the same commission rate that you pay to buy stocks. In contrast, you can only buy most conventional mutual funds at the end of the day. Commissions can vary widely, depending on negotiation with your broker or fund dealer.
Second, the MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investment. Instead of actively managing their clients’ investments, they generally try to invest so as to mirror the holdings and performance of a particular stock-market index.
ETF vs mutual funds, pros and cons: What else you need to know about ETFs
As mentioned, traditional ETFs are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.
Investors can buy ETFs on margin or sell them short. These funds have gained popularity among investors, mainly because many ETFs offer very low management fees.
What to watch out for with ETFs
International ETFs can have more risk
Some new ETFs can be more expensive—and risker—than traditional ETFs
ETFs can be volatile, depending on the stocks they hold.
ETF vs mutual funds, pros and cons: What you need to know about mutual funds
Mutual funds are diversified portfolios of equities and investments in which small investors can take part. They are an investment product, with individual shares being called units.
One interesting note about buying mutual funds comes from the Dalbar organization.
This U.S. research firm’s studies of top performing mutual funds show most of their investors who jump in at the top will lose money or make negligible returns. That’s because most investors in a top performing fund only buy into the fund after it has already made big gains. Investors also tend to sell former top performing funds only after a major slump in the value of their holdings. When you chase investment performance, it’s all too easy to buy at the top and sell at the bottom.
Types of mutual funds to stay away from:
Beware of buying vaguely described mutual funds
Avoid buying mutual funds that trade in derivatives
Avoid mutual fund managers who trade heavily
Avoid buying mutual funds with a lot of dead weight
Avoid buying mutual funds with anonymous managers
Get out of buying the riskiest “theme” mutual funds
ETF vs mutual funds, pros and cons: We think ETFs are generally the better investment
Here are three main reasons why we prefer ETFs over buying mutual funds:
ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in a mutual fund with a similar focus. With fees as low as 0.10% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher on their fund. ETFs can save you a lot of money and boost your returns over time.
ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.
ETFs have low turnover. Shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxescapital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.
Some large mutual fund companies are turning towards offering ETFs. Would you bother investing in these new ETFs, or is there a strategy that you already follow for your ETF investing?
Do you prefer the more actively managed mutual funds or would you rather invest in a less active ETF?
This article was originally published in 2017 and is regularly updated.
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