Debates regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs) are common in the investment community. Mutual funds and ETFs have benefits and drawbacks. Though ETFs offer market-based trading and typically lower expense ratios, investors may choose mutual funds over ETFs for several reasons.
Key Takeaways
- Mutual funds are an established investment vehicle, but ETFs have gained popularity.
- Some mutual funds are actively managed and have some risk due to leverage but limit the amount that can be used.
- ETFs are generally less expensive than mutual funds but with less management and reduced services.
Strategy and Risk Tolerance
Mutual funds are available for all different types of investment strategies, risk tolerance levels, and asset types. ETFs can be limiting as they are mostly passively managed indexed funds that invest in the same securities and mirror the chosen index.
Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.
Investing in mutual funds allows investors to choose a product that suits their risk tolerance levels and meets specific investment goals, such as dividend income or retirement planning.
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Active Management Without Leverage Risk
By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate a multiple of an index's returns. While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility.
Mutual funds are strictly limited regarding the amount of leverage they can use. Mutual funds can borrow capital, but they must ensure that they have "an asset coverage of at least 300 percentum," or only one-third of the total value of a fund. Mutual funds offer many combinations of security and risk to investors.
Individuals can choose mutual funds that focus on long-term capital gains that primarily invest in proven growth stocks but also look to benefit from early identification of up-and-coming businesses poised for exponential growth. The tried-and-tested stocks form a solid basis for long-term gains, while investments in newer or undervalued stocks provide the potential for rapid growth in exchange for a certain degree of risk.
Automatic Investment and Customer Service
Mutual funds offer automatic investment plans and ETFs do not. These services facilitate regular contributions and allow investors a consistent way to grow their investments, especially for retirement. The practice of investing a set amount each month allows for dollar-cost averaging, where investors pay less per share over time by purchasing more shares with the same amount of money in months when the share price is low.
Unlike ETFs, mutual funds can be purchased in fractional shares or fixed dollar amounts.
ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be slightly more costly, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer check-writing options and other shareholder services that ETFs don't provide.
Dividend reinvestment plans (DRIPs) take the stress of decision-making by automatically converting dividend distributions into investment growth.
How Are Mutual Funds Priced?
Mutual funds always trade at Net Asset Value (NAV). Mutual fund orders are executed once daily and all investors receive the same price.
Do Mutual Funds Have Minimum Investment Requirements?
Most mutual funds require a minimum initial investment based on a flat dollar amount.
How Are Mutual Fund Investors Taxed?
When a mutual fund sells securities in the fund, it may trigger capital gains for shareholders, even for those with an unrealized loss on the total mutual fund investment. Investors are liable for taxes on the capital gains earned.
The Bottom Line
Both mutual funds and ETFs can be smart investment choices, and many investors may choose both. However, there are some clear reasons why mutual funds may be the better choice for an investor's goals and strategy, such as those that want periodic investment or a wide variety of fund options.
FAQs
As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high. Mutual funds, by contrast, always trade without any bid-ask spreads.
Why are mutual funds safer than ETFs? ›
In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.
Why do investors prefer mutual funds? ›
Advantages of Mutual Funds. There are several specific reasons investors turn to mutual funds instead of managing their own portfolio directly. The primary reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
What is the downside of ETFs? ›
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Is it better to hold mutual funds or ETFs? ›
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
Which is better ETF or mutual fund? ›
Usually, ETFs have much lower fees and higher daily liquidity compared to mutual fund shares. ETF can be used for purposes like Hedging, Equitizing Cash, and for Arbitrage. ETF shareholders get a small portion of the gained profits, i.e, the dividends paid and interest earned.
What is the main advantage of mutual funds? ›
Key Takeaways
Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. There are economies of scale in investing with a group. Monthly contributions help the investor's assets grow. Funds are more liquid because they tend to be less volatile.
Should I switch from mutual funds to ETFs? ›
If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
What is the downside risk of a mutual fund? ›
What Is Downside Risk? Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price. Depending on the measure used, downside risk explains a worst-case scenario for an investment and indicates how much the investor stands to lose.
What is the #1 reason investors prefer mutual funds for investing? ›
One of the most significant benefits of investing in mutual funds is diversification. With mutual funds, you can invest your money in a variety of stocks, bonds, and other assets. This diversification helps in reducing the overall risk of your investment portfolio.
However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end, and back-end load charges, lack of control over investment decisions, and diluted returns.
What is the main difference between ETFs and mutual funds? ›
With a mutual fund, you buy and sell based on dollars, not market price or shares. And you can specify any dollar amount you want—down to the penny or as a nice round figure, like $3,000. With an ETF, you buy and sell based on market price—and you can only trade full shares.
Why don't I invest in ETFs? ›
ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
Has an ETF ever gone to zero? ›
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
What is the downside of ETF vs mutual fund? ›
ETFs are generally lower than those that are charged by actively managed mutual funds because their managers are merely mimicking the contents of an index rather than making regular buy and sell decisions, For some investors, the design of a passive ETF is a negative.
What are the advantages of a mutual fund? ›
Mutual funds offer several benefits to investors, including professional management, diversification, liquidity, low cost, tax benefits, affordability, safety, and transparency. However, investors need to consider several factors before investing in mutual funds.
Why might ETFs and mutual funds be a better choice than individual stocks? ›
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.
