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
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.
Why would you choose a mutual fund over an ETF? ›
If you focus on passively managed stock mutual funds, they're actually cheaper than passively managed stock ETFs, as you can see in the chart below. So in 2022, stock index mutual funds charged an average of 0.05 percent (asset-weighted), while a comparable stock index ETF charged 0.16 percent.
What is the #1 reason investors prefer mutual funds for investing? ›
Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. Investing with a group offers economies of scale, decreasing your costs. Monthly contributions help your assets grow. Funds are more liquid because they tend to be less volatile.
Why do people choose mutual funds over stocks? ›
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 main advantage of 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.
Are mutual funds better than ETFs? ›
Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
Are mutual funds ever better than ETFs? ›
Neither mutual funds nor ETFs are perfect. Both can offer comprehensive exposure at minimal costs, and can be good tools for investors. 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.
Which 3 are advantages to investing in mutual funds? ›
Mutual funds have plenty of advantages, including diversification, professional management, low costs, and convenience.
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 are mutual funds attractive to investors? ›
Mutual funds are popular in part because they offer investors the opportunity to diversify, and therefore spread out their risk over a number of investments. Mutual funds appeal to people because they give average investors the opportunity to invest in professionally managed funds.
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.
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 are the pros and cons of mutual funds? ›
One selling point is that they allow you to hold a variety of assets in a single fund. They also have the potential for higher-than-average returns. However, some mutual funds have steep fees and initial buy-ins. Your financial situation and investment style will determine if they're right for you.
What are the five cons of a mutual fund? ›
Potential Cons
- High fees. Mutual funds have expenses, typically ranging between 0.50% to 1%, which pay for management and other costs to operate the fund. ...
- Market risk. Just as with stocks and bonds, mutual funds generally have market risk, meaning that prices can fluctuate up and down. ...
- Manager risk. ...
- Tax inefficiency.
The industry has been prone to mis-selling of schemes which has resulted in lack of trust amongst common people. Mis-selling is when a Mutual Fund distributor sells schemes which makes him/her more commissions instead of selling the scheme which is suitable for client's goals and risk taking capacity.
What are the cons of investing in mutual funds? ›
Cons
- Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value.
- Cost: A mutual fund may incur sales charges either up-front or on the back end that are passed on to the investors. In addition, some mutual funds can have high management fees.
- Tax implications:
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.
