When it comes to planning for retirement and diversifying your investments, these days your choices pretty much fall between one of two major options – the ETF vs mutual fund.
Recently while rolling over my old 401(k) to an IRA with Vanguard, I had to make a very big decision as to which way I wanted to go. I could stick with their low cost mutual funds which I was very familiar with. Or I had the option to pick commission free ETF’s.
Having six figures of retirement savings, this was in no way a decision to be taken lightly! Choosing the right type of funds could mean saving myself thousands and thousands of dollars in unwanted expenses or trouble later on when I’m ready to start making withdraws from my funds.
I’ve been an investor in mutual funds for over a decade now. But ETF’s were interesting to me. They seem to always be on the cover of every financial magazine, and lots of people in the early retirement forums always talk about having them in their portfolio.
Ultimately, between the ETF and mutual fund, which one did I pick to go with? I chose to go with mutual funds. And here’s why.
In this post, I will explain some of the research I did, some of the pros and cons of both, and why I decided that mutual funds would be a better fit for me.
What Are Mutual Funds and ETFs?
I’m sure everyone reading this blog already somewhat understands what a mutual fund is. A mutual fund is a collection of various stocks, bonds, and sometimes other assets all rolled into one financial product that you buy from a financial company (like Vanguard or Fidelity). They can be actively managed or passive – meaning they are either managed by a fund investor manager or simply modeled after a standard index fund.
ETF’s, on the other hand, are more like the new kid on the old financial block. Even though not as many people tend to invest in them as mutual funds, they are all the rage with new investors. Since being introduced in the early 2000’s, the ETF market is expected to expand by as much as 15 to 30% over the next few years.
The term ETF is short for “exchange traded fund”. You can think of an ETF as being very similar to a mutual fund. They, too, are also a collection of different stocks, bonds, and other financial products. The major difference is that an ETF trades like a stock. It’s value fluctuates all day long, and so they can be purchased and sold at different prices throughout the open market. Mutual funds, on the other hand, only change value and are traded once per day (at the end of the day).
So Which is Better – An ETF or Mutual Fund?
Like I mentioned, I ultimately decided to go with mutual funds. Though ETF’s were very enticing, there were three main reasons why I liked mutual funds better.
1. Historical Data:
My first reasons is experience. Mutual funds have been around for almost 100 years; almost as long as stocks themselves. Some of the funds that Vanguard offers have been around since the time of the Great Depression. Their fund managers, investment practices, processes, and experience date back for decades.
More importantly, there’s oodles of data to prove it. Since I am a long term investor and often filter out short term noise and market fluctuations, I tend to prefer stocks that have well over 10 years of data that I can look back at and compare against market indices.
ETFs, on the other hand, are a relatively new type of investment. Although things seem to be going well for them both now and for the foreseeable future, it remains unclear whether they will stand the test of time. Though they may have survived the past two recent recessions, there is no historical data necessarily to back up whether or not that particular ETF will perform well given 20, 30, 50, or even 100 years of market turbulence.
It’s like when something goes wrong in your office, and you have to decide whether you want to ask for help from the new hot-shot who just started last year, or the guy with a few grey hairs that’s been around for the last 20 years. Though both may have good ideas, when it comes to putting my money where my mouth is, I’m going to pick experience every time!
2. Bid-Ask Spread:
Secondly, with ETF’s, there’s a matter of something called the bid–ask spread.
The ETF bid–ask spread is the difference between the price you’re willing to sell at and what someone is willing to buy it for.
Even though by itself an ETF has a certain value due to the stocks and bonds it represents (something called NAV or net asset value), that still alone doesn’t justify what someone is willing to pay you for the ETF. In reality, buyers could offer you a lot less.
This could be a problem with some ETF’s. Suppose you decide to invest in an actively managed ETF and market falls out of favor with the assets it represents. You may end up having to sell your investment at a discount and not getting your full value.
With mutual funds, this is not a problem. Mutual funds are tallied up at the end of the day when the markets close. So in essence investors never really feel the same sort of pressures as they would with stocks or ETF’s of selling at a discount.
3. Expenses and Commissions:
Finally, the last thing to consider between mutual funds and ETF’s are the expense ratios and commissions.
Unlike with mutual funds, ETF’s charge a commission every time you buy and sell them (just like a stock). Thankfully, with my Vanguard account, because of the number of investments I already have, it appears that if I did want to buy ETF’s they would be commission free.
One place where ETF’s are making an absolute killing and why they are so popular is their extremely low expense ratios. On average, their expense ratios can be lower than 0.1%. Compare that to the average mutual fund expense of 1.0% and that is a humongous chunk of savings that will result in a portfolio of thousands and thousands more dollars over time.
Again, with my situation and using Vanguard, the issue of expense ratios really isn’t much of an issue at all. Of the six or so mutual funds I selected for my IRA rollover portfolio, the average annual expense ratio was 0.2%. If we were to do the math on that difference of 0.1% in expenses and compound my losses over the next 10 years before I plan to make an early retirement, that works out to just about $6,000. When we’re talking about six-figure 401(k)’s, that’s not really a ton of money to make much of a difference.
Do I think ETF’s can be a good products? Absolutely! Their low cost approach and index-like models make them very strong contenders to be wonderful financial products in the future.
But do I want to gamble my entire retirement savings on them? Sorry. I’m going to stick with tried-and-true mutual funds and go with what I know works well.
I’m sure that given enough time, I may start to dabble in ETF’s and integrate them more into my different retirement savings funds. But for now, when it comes to mutual funds versus ETF’s, I’m going to stick with what I know and understand the best.
Readers – when it comes to choosing between an ETF vs mutual fund, which one do you prefer? What have been your pros and cons with using either?
Images courtesy of Andreas Poike | Flickr and Daniel Oines | Flickr
Jayson @ Monster Piggy Bank says
What I like about is that when I buy a mutual fund, I am able to diversify without the numerous commission charges. MMD, imagine if I had to buy the 10-20 stocks needed for diversification.
Exactly. Although I get commission free trades, for most people it would still be a pain in the butt.
EL @ Moneywatch101 says
I think we all tend to go with something that’s been around a while and feel comfortable. I think having a good mix of both doesn’t hurt. The cost to own ETF’s is way less over a long term life span that may be worth it. Mutual funds have constant yearly fees that eat away at the performance. For me I will stick with low cost mutual funds, ETFs, and individual stocks for a long term investing approach.
Very true, and I think at some point I will also dip into the ETF pool. They certainly aren’t going away. But for now my “old man” ways keep me from trying new things and just sticking to what I know.
Mike Rawson says
Interesting comparison. I can see why the long track record of mutual funds would be attractive, but I didn’t follow the comment about Vanguard funds dating back to the depression. I thought Vanguard was founded in 1975? (ETFs date back to 1989.)
Here in the UK, ETFs were much cheaper than mutual funds until a recent regulator review banned trail commission to financial advisers. Now the gap is a lot closer.
On balance, I feel more comfortable with exchange-traded products, so my new money is going there. I haven’t bothered to switch my historical mutual funds though, and following the review it probably isn’t worth it anymore.
Thanks and welcome to the site.
I meant that mutual funds themselves have been around for almost 100 years, not Vanguard the company.
If your comfortable with ETF’s, then you should probably stick to them. In essence, that’s kind of what the article was about – investing in what you know and believe will be the best long run.
Mutual funds and ETFs, to me, appear to be almost the same. They’re really the same type of investment vehicle, what with both simply being a basket of diversified stocks or bonds that follow a particular theme or index. Daily price fluctuations or trade commissions shouldn’t scare away a long term investor. No one has ever not bought $5000 worth of Coca-Cola because they had to pay a $7-10 commission.
And I’ll compare the historical performance of funds vs ETFs to that of personal loans vs P2P loans. Like I said on my guest post on this site way back when (“Countering The Arguments Against P2P Lending”, for those who missed it), the difference between the two is window dressing and you can use one type of loan to predict how the other will fare over time. Same here. Outside of the fact that an ETF trades like a stock, what difference is there truly between that and a mutual fund.
Unless I missed something, none at all.
To me, the big difference seems to be between actively managed mutual funds and passively managed index funds. THAT’S where the difference lies. Personally, I prefer the latter.
Still, this article is probably the best explanation of the differences between mutual funds and ETFs that I’ve seen online. Thanks, MMD!
ARB–Angry Retail Banker
That’s actually a really good point about association. I’m sure that given enough time, ETF’s and mutual funds will be proven to produce basically the same returns over the long run.
I’m sure eventually I will add ETF’s to my portfolio, but more likely in my taxable accounts rather than my tax-sheltered ones. That way, unlike mutual funds, I can defer taxes on capital gains/dividends off until the assets are sold.
JP at TheMoneyHabit.Org says
So I was thinking about this the other day in regards to Vanguard’s total stock market index mutual fund vs its near identical ETF. The pro to the mutual fund is no commissions if you buy through the Vanguard platform. The advantage of the ETF is the ability to set limit orders (for example if you need to liquidate a chunk over several days or weeks and want to have finer control over what price you would choose to sell at) as well as the ability to get the expense ration of admiral shares even if you don’t have $10k at once to invest.
I ultimately decided on the mutual fund option as well. But I’ll be keeping my eye on ETFs,
Good points JP. While there are probably a lot of good reasons to go with ETF’s, I’m just not totally convinced yet about their long term viability. I’d like to see how, as a product, they behave over one or two more crashes. We already know mutual funds won’t dissolve, and that’s why I like them.
Mr. RIP says
Amazing article and very comprehensive analysis.
Sadly Vanguard is not available (with the same benefits) outside US, which makes ETFs better than Mutual due to TER.
Vanguard isn’t available outside the US? I did not know this.
This was a good analysis of the two products and you pointed out some good reasons for taking the mutual funds over the ETF. They are both great investments and really the decision between buying either of them is probably just a matter of preference. ETFs are definitely becoming a lot more popular though nowadays especially since the barrier for entry is lower.