Investors looking to diversify their stock and bond holdings at relatively low cost—without having to buy scores of specific securities—often turn to the world of funds. Exchange-traded funds (ETFs), index mutual funds and actively managed mutual funds can provide broad, diversified exposure to an asset class or region or to a specific market niche.
So how do you decide what’s right for you? Whether you trade actively or you’re a buy-and-hold investor, your investing style, your tax sensitivity and your interest in a fund’s market-beating potential may all figure into your decision. With 1,700 ETFs, around 350 index mutual funds and more than 7,200 unique actively managed mutual funds in the market,1 you certainly have plenty of choices.
Let’s look at the benefits of each type of fund and a few trading scenarios.
ETFs have been around for a little more than 20 years but have already become extremely popular. The assets held by U.S. ETFs had grown to just shy of $2 trillion as of January 2015, according to the Investment Company Institute (ICI), an industry association.
ETFs trade like stocks and are primarily passive investments because they seek to replicate the performance of a particular index. This is the source of one of their key strengths: Passively managed funds tend to have lower costs than actively managed ones. ETFs generally have low annual operating expenses, averaging 0.60% across all ETFs and going as low as 0.04%.2 In many cases, an ETF may be the least expensive way to gain exposure to a given asset class. ETFs are also generally tax efficient because they tend not to distribute a lot of capital gains, as tracking an index usually doesn’t require frequent trading. ETFs may involve trading commissions, but some brokerages offer commission-free ETFs.
Looking at an ETF’s returns relative to the benchmark it tracks can give you a sense of how successful it has been in following its strategy. When the returns of a given ETF and the underlying index differ, this is called “tracking error.” A high tracking error means the fund is straying from the index it is designed to mirror.
Consider investing in an ETF if:
- You trade actively. Intraday trades, stop orders, limit orders, options and short selling are all possible with ETFs, but not with mutual funds.
- You want niche exposure. ETFs focused on specific industries or commodities can give you exposure to particular market niches. Niche investing often isn’t possible with index mutual funds, though some actively managed niche funds might be available.
- You’re extremely tax sensitive. In general, ETFs have the edge over index mutual funds and actively managed mutual funds.
Mutual funds are very popular among investors, with U.S. assets totaling nearly $16 trillion as of January 2015, according to the ICI. You generally buy mutual funds directly from investment companies instead of on an exchange, so their prices reflect their net asset value (NAV), or the underlying value of the securities the funds hold, rather than supply and demand. Unlike ETFs, mutual funds don’t have trading commissions, but you’ll have to pay operating expenses and, potentially, other sales fees, or “loads.” Costs can also vary depending on whether a mutual fund is actively or passively managed.
Index mutual funds
Like ETFs, index mutual funds are considered passive investments because they mirror an index. That means they can also offer low operating expenses—an average of 0.40% and a low end of 0.02%, even lower than ETFs.3 Differences in how these two investments are structured, though, mean they might be appropriate for different circumstances.
Consider investing in an index mutual fund if:
- You’re making small, regular investments. Consider index mutual funds if you make monthly or quarterly IRA deposits or use dollar-cost averaging, a strategy in which you manage risk by investing fixed sums of money at regular intervals. Making regular small investments can be particularly cost-effective if you’re investing in a no-load, no-transaction-fee mutual fund. In contrast, making regular trades with ETFs could mean you have to pay trading commissions (if you’re not investing in commission-free ETFs that is).
- You can buy an index mutual fund that has lower annual operating expenses. Don’t assume ETFs are always going to be the lowest-cost option. You may be able to find an index fund with lower costs than a comparable ETF, and spare yourself the potential trading costs.
- The ETF is thinly traded. If the ETF you’re considering trades infrequently, this could lead to a large bid/ask spread, or a discrepancy between the price you pay and the NAV per share of the fund’s underlying securities. Mutual funds, by contrast, always trade at NAV without any bid-ask spreads.
Actively managed mutual funds
The investments in an actively managed mutual fund are selected and managed by a portfolio manager and a group of research analysts. As a result, such funds can adjust to changing market conditions. For example, an active manager can adopt a more conservative posture in rough markets and play defense. Such responsiveness comes at a premium, though. Actively managed funds are the most expensive of the three options considered here, as they include expenses to compensate the management team.
Consider investing in an actively managed mutual fund if:
- You want a fund that potentially could beat the market. The main reason people invest in actively managed funds is the potential that they might beat their benchmarks (though most aren’t able to do so consistently).
- You want the broadest possible selection of funds. There are many more actively managed mutual funds than there are actively managed ETFs (which work similarly, with a fund manager making frequent changes to the portfolio, except in an ETF structure). As you’ll have more choices, you’ll likely want to go with a mutual fund.
ETFs, index mutual funds and actively managed mutual funds can provide broad diversification at relatively low cost, but the details matter. Make sure that a given investment aligns with your goals before you buy.
1Morningstar as of 7/31/2014.
2Morningstar Direct as of 12/31/2014.