The debate regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs), has been a hot topic in the investment industry for some time. Like any investment product, both mutual funds and ETFs have their benefits and drawbacks and are better suited to some investors than others.
Though ETFs have become rather fashionable because of their market-based trading and typically lower expense ratios, there are still solid reasons to choose mutual funds over ETFs.
Wider Variety
The chief advantage of mutual funds that cannot be found in ETFs is variety. There is a virtually unlimited number of mutual funds available for all different types of investment strategies, risk tolerance levels and asset types.
In general, ETFs are passively managed indexed funds that invest the same securities as a chosen index in the hopes of mirroring its returns. While this is a perfectly viable investment strategy, it is pretty limiting. Mutual funds offer the same type of indexed investing options as ETFs, and they offer an impressive array of actively and passively managed options that can be fine-tuned to cater to investors' needs. Investing in mutual funds allows you to choose a product that fits your specific investment goals and risk tolerance level. Whether you want a more stable investment that generates modest returns, an investment that provides regular income each year or a more aggressive product that seeks to beat the market, there is a mutual fund for you.
Active Management Without Leverage Risk
Of course, there are some more actively managed ETFs and a newer breed of product that provides a higher-risk/higher-reward option. By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate some multiple of an index's returns. While these securities still track a given index, the use of debt to bet big without the shareholder equity to back up the gamble makes leveraged and inverse ETFs completely different species of investments.
Leveraged and inverse ETFs are the topic of much discussion because of their fickleness. Though they can be very lucrative options if the market performs as predicted, the combination of leveraged returns and day-to-day market volatility can make them dangerous investments over the long term.
Clearly, the ETF options available tend to be fairly black and white – either extremely passive indexed funds that provide moderate returns with little chance of big gains or aggressively managed high-yield funds or risky leveraged products. There is little room in the middle for investors who want a certain degree of stability with just a dash of risk. Conversely, mutual funds come in all possible combinations of security and risk.
If you want an investment that focuses on long-term capital gains, for example, you can find a mutual fund that primarily invests in proven growth stocks but also looks 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. Unlike ETFs, mutual funds don't have to be all-or-nothing investments.
In addition, mutual funds are strictly limited with regard to the amount of leverage they can use. While it is possible for a mutual fund to borrow funds equal to 33.33% of its shareholder equity, most eschew the use of leverage.
Service Quality
ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be a slightly costlier option, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer free funds transfers, check-writing options and other shareholder services that ETFs don't provide.
Automatic Investment Options
Some of the most useful services offered by mutual funds that cannot be found investing in ETFs are automatic investment plans. These services facilitate regular contributions without you having to lift a finger, helping you grow your investment effortlessly.
By utilizing these options, you can have your mutual fund investment automatically increased by a predetermined amount each month. This provides an easy way to grow your nest egg without having to make the monthly decision to allocate those funds to your portfolio or use them for other things. Given a few hundred dollars of discretionary income each month and the choice of how to use it, many people might elect to spend it on non-essential activities or purchases rather than making the smart choice of investing it. An automatic investment plan makes that choice for you.
In addition, mutual funds often offer dividend reinvestment plans (DRIPs) that allow you to use any dividend income generated by the fund to purchase additional shares. Like an automatic investment plan, DRIPs take the stress of decision-making out of the equation by automatically converting dividend distributions into investment growth.
No Commission Fees
Another reason mutual funds can be the better option is if your investment plan includes incremental investment over time. While ETFs are often touted as the cheaper option because of their relatively low expense ratios, shareholders still have to pay broker commissions each time they buy or sell shares. If you plan to make one large investment, ETFs may be the cheaper option if one of the products available can meet your investment goals.
Many people, however, prefer to grow their investments over time. This gives you the chance to see how a product performs before committing fully, and it can be a much more sustainable investment strategy. Not everyone has $10,000 or more to invest all at once. In addition, the practice of investing a set amount each month, called dollar-cost averaging, means you will end up paying less per share over time; you will purchase more shares with the same amount of money in months when the share price is low.
Though mutual funds sometimes carry up-front fees for first-time investors, they make it cheap and easy to increase your investment down the road. In addition, the availability of the automatic investment and DRIP options makes incremental mutual fund investment virtually effortless. To build your ETF investment in the same manner, you would incur commission or transaction fees each month, which can substantially reduce your take-home profit.
Conclusion
Though both mutual funds and ETFs can be smart investment choices, there are some clear reasons why mutual funds may be the better choice, depending on your investment goals and strategy. However, there's no reason you cannot further diversify your portfolio by investing in both asset types if they serve your long-term goals in different ways.
FAQs
Wider Variety. The chief advantage of mutual funds that cannot be found in ETFs is variety. There is a virtually unlimited number of mutual funds available for all different types of investment strategies, risk tolerance levels and asset types.
What is better mutual funds or ETFs? ›
ETFs can be more tax-efficient than actively managed funds due to lower turnover and fewer capital gains. ETFs are bought and sold on an exchange at different prices throughout the day while mutual funds can be bought or sold only once a day at one price.
What are 2 key differences between ETFs and mutual funds? ›
ETFs actively trade throughout the trading day while mutual fund trades close at the end of the trading day. Mutual funds are actively managed, and ETFs are passively managed investment options.
Why is it better to invest in mutual funds? ›
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.
Why do people prefer to invest in mutual funds? ›
Low Cost — An important advantage of mutual funds is their low cost. Due to huge economies of scale, mutual funds schemes have a low expense ratio. Expense ratio represents the annual fund operating expenses of a scheme, expressed as a percentage of the fund's daily net assets.
What is the biggest 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.
Are mutual funds better than ETFs long term? ›
While actively managed funds may outperform ETFs in the short term, long-term results tell a different story. Between the higher expense ratios and the unlikelihood of beating the market over and over again, actively managed mutual funds often realize lower returns compared to ETFs over the long term.
Are mutual funds safer than ETFs? ›
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.
What is one of the biggest advantages of a mutual fund? ›
Risk Diversification: One of the biggest benefits of mutual funds is risk diversification. Every stock is subject to three types of risk – company risk, sector risk and market risk. Company risk and sector risk are unsystematic risk, while market risk is known as systematic risk.
What is the main point about mutual fund? ›
A mutual fund is a pool of money managed by a professional Fund Manager. It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities.
Mutual funds tend to be less risky than individual stocks, because they are more diversified — meaning they contain a mix of investments.
What are 3 disadvantages to owning an ETF over a mutual fund? ›
So it's important for any investor to understand the downside of ETFs.
- Disadvantages of ETFs. ETF trading comes with some drawbacks, which include the following:
- Trading fees. ...
- Operating expenses. ...
- Low trading volume. ...
- Tracking errors. ...
- Potentially less diversification. ...
- Hidden risks. ...
- Lack of liquidity.
ETFs give you an efficient way to diversify your portfolio, without having to select individual stocks or bonds. They cover most major asset classes and sectors, offering you a broad selection.
What are the advantages and disadvantages of mutual funds and ETFs? ›
Some of the advantages of this kind of investment include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.
Are mutual funds really worth it? ›
Key Takeaways. Mutual funds are largely a safe investment, seen as being a good way for investors to diversify with minimal risk. But there are circ*mstances in which a mutual fund is not a good choice for a market participant, especially when it comes to fees.
What are the risks of mutual funds? ›
Mutual Fund Schemes are not guaranteed or assured return products. Investment in Mutual Fund Units involves investment risks such as trading volumes, settlement risk, liquidity risk, default risk including the possible loss of principal.
Are mutual funds more tax efficient than ETFs? ›
In a nutshell, ETFs have fewer "taxable events" than mutual funds—which can make them more tax efficient. Find out why. ETFs can be more tax efficient compared to traditional mutual funds.
Why are mutual funds more expensive than ETFs? ›
The end results: mutual fund shareholders end up paying income taxes on those distributions, and the fund company spends time handling transactions, increasing its operating expenses. Since the sale of ETF shares does not require the fund to liquidate its holdings, its expenses are lower.
Do mutual funds have higher fees than ETFs? ›
ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments. And ETFs do not have 12b-1 fees.
Should I switch my mutual funds to ETFs? ›
If you're paying fees for a fund with a high expense ratio or finding yourself paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice for you.
A slight majority of actively-managed mutual funds that invest in U.S. large-cap stocks lagged the S&P 500 index again in 2022, struggling over the long term to beat the index, according to an annual scorecard from a division of S&P Global.
Is there a downside to ETFs? ›
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment.
What is the safest type of mutual fund? ›
Money market mutual funds = lowest returns, lowest risk
They are considered one of the safest investments you can make. Money market funds are used by investors who want to protect their retirement savings but still earn some interest — often between 1% and 3% a year. (Learn more about money market funds.)
What is the downside risk of mutual funds? ›
Downside risk refers to the probability that an asset or security will fall in price. It is the potential loss that can result from a fall in the price of an asset as a result of changing market conditions.
What are the potential benefits of mutual funds? ›
What are the potential benefits of investing in mutual funds? Because mutual funds can invest in many different stocks or bonds, they give investors an easy way to diversify their portfolio. Mutual funds offer an affordable way to invest in a wide array of stocks without paying transaction fees for each stock held.
What are the benefits of mutual funds *? ›
The Advantages of Mutual Funds. The biggest advantage of investing in a mutual fund scheme is that you can redeem your units anytime you want. Unlike FDs (Fixed Deposits), mutual funds offer very flexible and convenient withdrawals.
What are the two main fees associated with a mutual fund? ›
Mutual fund fees generally fall into two big buckets: Annual fund operating expenses: Ongoing fees toward the cost of paying managers, accountants, legal fees, marketing and the like. Shareholder fees: Sales commissions and other one-time costs when you buy or sell mutual fund shares.
What is unique about mutual funds? ›
Affordability. Most mutual funds set a relatively low dollar amount for initial investment and subsequent purchases. Liquidity. Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees.
Why do people invest in mutual funds rather than stocks? ›
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.
Why is it better to invest in a mutual fund than an individual stock? ›
Instant diversification -- Because you're investing in a basket of assets, you have instant diversification, and therefore lower risk, and don't need to buy multiple individual stocks to diversify your portfolio.
One should have time to enjoy that money as well and hence he advised investors to invest in stock market as it gives higher return than mutual funds. However, every time you invest in a stock and hold for long won't yield higher than mutual funds yield.
Why are mutual funds less tax efficient than ETFs? ›
Capital gain distributions from ETFs and mutual funds are taxed at the long-term capital gains rate. Comprehensively, ETFs usually generate fewer capital gain distributions overall which can make them somewhat more tax efficient than mutual funds.
Do ETFs have lower expenses than mutual funds? ›
Most ETFs have attractively low expenses compared to actively managed mutual funds and, to a lesser extent, passively managed index mutual funds. ETF expenses are usually stated in terms of a fund's operating expense ratio (OER).
Are ETFs a good investment for retirees? ›
Bottom Line. ETF benefits, including simplicity, low expenses and tax efficiency, make ETFs a worthwhile investment for retirement. Popular types of ETFs for retirement include dividend ETFs, fixed-income ETFs and real estate ETFs.
Are mutual funds good long term investments? ›
Generally speaking, mutual funds — especially equity mutual funds — should be considered a long-term investment.
Do ETFs outperform the market? ›
May underperform stock investments: Even in a good year, an ETF based on a basket of stocks can underperform a single stock investment that is outperforming the market. Management fees: Even index ETFs have management fees, and actively traded ETFs' management fees can be quite high.
What are the advantages of ETFs versus stock index mutual funds? ›
ETFs are more tax-efficient than index funds by nature, thanks to the way they're structured. When you sell an ETF, you're typically selling it to another investor who's buying it, and the cash is coming directly from them. Capital gains taxes on that sale are yours and yours alone to pay.
What is the downside of ETF vs mutual fund? ›
No-load mutual funds are also available, but these will charge other fees, such as annual expense ratios. Taxes: The biggest difference between mutual funds and ETFs when it comes to taxes is that mutual funds tend to create a lot of capital gains for clients, while ETFs don't.
Why are ETFs so much cheaper than mutual funds? ›
While they mirror each other in some ways, they each have their own unique structure and investing approach. ETF fees tend to be lower than mutual fund fees mostly because unlike most mutual funds, the majority of ETFs are passively managed. This translates to fewer out-of-pocket costs for investors.
What are the pros and cons of mutual funds? ›
Mutual funds are one of the most popular investment choices in the U.S. Advantages for investors include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
A mutual fund provides diversification through exposure to a multitude of stocks. The reason that owning shares in a mutual fund is recommended over owning a single stock is that an individual stock carries more risk than a mutual fund. This type of risk is known as unsystematic risk.
Are mutual funds more secure than ETFs? ›
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.
Are there any disadvantages to ETFs? ›
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
Should I invest in a fund or ETF? ›
The Bottom Line. Both index mutual funds and ETFs can provide investors with broad, diversified exposure to the stock market, making them good long-term investments suitable for most investors. ETFs may be more accessible and easy to trade for retail investors as they trade like shares of stock on exchanges.
Why might an investor not want to use a mutual fund? ›
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 risk of mutual funds? ›
All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.
