Mutual Funds vs. ETFs - Which I Prefer and Why

by Michael on May 24, 2013 · 5 comments

Image of Mutual Funds Sign

The first exchange traded fund (ETF) was launched 20 years ago, in 1993. Since then, ETFs have gained a great deal of popularity.

So, if given the choice between an old school (open-end) mutual fund and an equivalent ETF, which would you choose and why?

Personally, I remain partial to mutual funds. Yes, we do have some ETFs in our portfolio but for ongoing investments, I always go with mutual funds. Curious as to why? Keep reading.

Before I unveil my reasoning, however, I thought it would be instructive to consider some of the key differences between mutual funds and ETFs.

Trade-ability

For starters, ETFs are traded throughout the day just like regular stocks. Thus, market prices fluctuate on an ongoing basis and you can get in and out of your position at the drop of a hat. In contrast, mutual funds are traded (and priced) just once per day, at the close of the market.

Because ETFs are traded like stocks, you can also use more specialized trading techniques with them. This includes limit and stop loss orders as well as short sales. In fact, you would be well-advised to use limit orders when trading ETFs to protect against disasters due to intraday volatility (flash crashes and the like).

Transaction costs

Due to their similarity to stocks, it should come as no surprised that you may face brokerage fees when trading ETFs. That being said, most major brokerages now offer a slate of commission-free ETFs, so it’s reasonable to think that you’ll be able to invest with ETFs without paying any commissions.

Operating costs

In very general terms (and ignoring transaction costs; see above), ETFs are cheaper to own than are equivalent mutual funds. Consider, for example, that Investor Shares of the Vanguard Total Stock Market Index Fund (VTSMX) has an expense ratio of 0.17% vs. 0.05% for the ETF (VTI).

That being said… Admiral Shares (available to those with balances of $10k or greater in a particular fund) erase this difference. Indeed, Admiral Shares of the Vanguard Total Stock Market Index Fund (VTSAX) have an ETF-like expense ratio of 0.05%.

Tax efficiency

Though ETFs are often considered to be more tax efficient than traditional mutual funds, a quick look at the numbers reveals that this isn’t always (or even often) the case. For example, returning to our total stock market comparison…

Based on data from Morningstar, the “tax-cost ratio” of the different share classes (Investor, Admiral, and ETF) is virtually identical. In fact, if anything, the traditional mutual funds come out (very) slightly ahead.

While I’m sure you could find cases where the opposite is true, the differences are so small that it’s hardly worth worrying about.

Why I prefer mutual funds

So… Given the above, why do I prefer mutual funds? Mainly because they allow me to easily invest in round dollar amounts vs. having to buy multiples of whole shares.

The other differences between mutual funds and ETFs are (imho) either miniscule or irrelevant. The costs are basically the same and I don’t really care about being able to trade in real time, so it really just comes down to convenience.

Of course, it doesn’t have to be one or the other. There’s no reason you can’t hold a combination of traditional mutual funds and ETFs. This is especially true if you have the option of converting between share classes, as we do with Vanguard.

In that case, you can accumulate shares using the mutual fund and then periodically convert (without tax consequences) to the ETF share class. In our case, that’s exactly what we did during a spate of tax loss harvesting a few years ago, resulting in a combination of share classes.

Even still, the vast majority of our holdings are in traditional mutual funds.


1 Deacon @ Well Kept Wallet May 28, 2013 at 9:31 pm

I am a big fan of ETF’s because of the low cost to buy and to hold. Schwab has a good selection of funds that don’t have commissions. However, it is the lack of a track record that makes me hesitant on buying some.

2 Martin May 29, 2013 at 1:08 am

I like ETFs better than mutual funds. If you go into sectors, industries, or individual asset groups, the expense ratio suddenly jumps up and you seldom find it below 1.8%
For example my 401k funds are all above 2%, which sucks.
The next reason is that mutual funds seldom beat the market, so you not only make less money overall but that less money you made is then eaten up by the fees (expense ratio). The funds have a turnover, which you won’t avoid at all and that ads tax you have to pay. So ETFs seem to me a better and cheaper solution

3 Little House May 29, 2013 at 10:08 am

I also like mutual funds because they appear easier to invest in; it’s may also be because that’s the only investment I currently have. I started by researching a handful through my insurance company (who also handles banking, etc.) and picked one that is a stellar fund. I can invest a small amount every month with my small-ish income. Perhaps as I earn more over the next year or so I’ll look into ETF’s, but I’m perfectly happy with mutual funds for now.

4 Michael May 29, 2013 at 12:11 pm

Martin: Fair point re: ETFs if you’re targeting specific sectors. I’m looking at this more from a total market perspective so, for our purposes, there’s very little in the way of cost advantages (effectively zero if you invest w/Vanguard and qualify for Admiral shares).

When you say “mutual funds seldom beat the market”… That is (imho) a dangerous line of thinking since it’s virtually impossible to find a strategy that consistently beats the market on a risk-adjusted basis. I’m perfectly happy with market performance minus 0.05% for expenses.

5 Martin May 29, 2013 at 7:15 pm

Michael: There are strategies which can beat the market by several miles on long run (even consistently). the problem is that humans are unable to apply and stick to it due to emotions, so their results are even worse than mutual funds’ ones.
Of course I am not criticizing any one’s strategy and everybody must pick and stick to a strategy which makes him/her comfortable. I also wanted to be a swing trader until I found out that it wasn’t a strategy for me. So I landed at dividend growth strategy (which I believe is far superior strategy than mutual funds 😉 but that is my opinion only and others may disagree, which is completely fine.

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