Discover the benefits of ETFs over mutual funds so you can make better decisions when it comes to buying investments that follow indexes

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but exchange-traded funds—ETFs—can also play a role in a portfolio.

ETFs are one of the biggest advances for individual investors since the introduction of discount brokers. Both help you cut costs—but both of these developments expose you to risk as well.

Meanwhile. if you want to make a particular type of investment in a narrow field, ETFs may give you a much cheaper way to do so than conventional mutual funds. This is one of the benefits of ETFs over mutual funds. Here too, however, ETFs may add risk—including many opportunities to make truly hare-brained investments.

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One of the benefits of ETFs over mutual funds is cutting the cost of management fees for investors

ETFs started out as what you might think of as plain-vanilla, discount versions of mutual funds. Instead of actively buying and selling stock in the ETF’s portfolio in an attempt to maximize profit, the ETF manager simply runs the fund so as to mirror the performance of a market index.

This strategy cuts costs for the operating firm. As a result, the ETF may charge an MER (management expense ratio) of as little as 0.10%, compared to an average MER on conventional mutual funds of 2.0% to 2.5%.

Thanks to this fee discrepancy, ETFs automatically perform better than the majority of actively managed mutual funds. That’s because few mutual funds beat the index by a wide enough margin to offset their MER.

Note too that ETFs trade on stock exchanges, just like stocks; this means you can buy or sell (or sell short) any time the market is open. In contrast, you can only buy or sell a mutual fund at the end of the day, and you can’t sell a mutual fund short.

Here are some potential drawbacks to ETF investing…

Some ETFs use derivatives to carry out complex trading strategies. Many of these strategies eventually fail in practice. They can produce healthy profits for the ETF’s operators, while losing money for the vast majority of the ETF’s investors.

Some ETF operators create their own index, then set up an ETF to mirror that index. This alone can add to risk. That’s because the design or component stocks of the ETF operator’s index may have quirks that expose you to unforeseeable risks. Frequent changes in the design or the component stocks may also hurt performance or raise volatility.

Although ETFs can cut the cost of investing, that’s different from building a stock portfolio that fits your goals, financial circumstances and temperament. In fact, rather than helping you make more money, the variety of ETFs available today may spur some investors to act on trend-following or theme-investing urges.

This is called “top-down investing.” It essentially involves betting on predictions about the future.

Understand “top-down investing” and “bottom-up investing” so you can make better stock or ETF picks

Using the top-down approach—you might call it predictive finance—you downplay what’s currently going on. Instead, you focus on trying to figure out what happens next. You may disregard lots of details about stocks you buy. Instead, you’re likely to zero in on external factors such as stock-market trends, the economy, interest rates, gold and so on. Or, you may focus on a single key trend, event or detail.

Top-down advisors can draw negative or positive conclusions from these trends. In the late 1990s, for instance, many investors took a highly positive top-down view of the profits that businesses could make by taking advantage of the Internet. Some of these investors routinely bought any new issue that claimed to have an Internet-based business plan. A handful of Internet stocks have done extraordinarily well since then, of course. However, the majority “crashed and burned”—generating miserable results if not total losses.

By the time beginning investors have built up enough of a stake to begin serious investing, most have settled on a mix of top-down and bottom-up. As the years pass, successful investors tend to put more weight on bottom-up investing. They like the way it cuts risk.

“Top-down” ideas and events get lots of attention in the media and in brokers’ research, so they tend to get “priced into” the market, as traders say. In other words, investors react to this kind of potential calamity or windfall by paying a little less or more for investments than they otherwise would.

Of course, investors may underestimate or fail to recognize good or bad fundamental information for lengthy periods. They may fail to take hidden assets into account for years. Ultimately, good investments go up and bad investments go down, but both can seem to ignore the fundamentals for months if not years.

So, all in all, it pays to focus on the fundamental bottom-up Successful Investor approach—although you need patience to profit from it.

Bonus tip: Use our three-part Successful Investor approach to build a better portfolio.

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What are some examples where you have selected mutual funds over comparable ETFs?

With many ETFs having lower costs and lower risk, is there a good reason for investors to look at mutual funds?