Investors looking to diversify their stock and bond holdings at relatively low cost 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, region or a specific market niche, without having to buy scores of individual securities.
The challenge, however, lies in narrowing down the type of investment best suited to help you achieve your goals. Do you choose a classic ETF that tracks an index—or a low-cost index mutual fund that does the same? Or perhaps the newer breed of ETF called a fundamentally weighted index ETF that may improve a portfolio’s overall risk-adjusted performance? Or maybe an actively managed mutual fund?
There may not be a single answer. Many investors may benefit from owning a mix of these funds. For example, if you want the flexibility to trade based on the latest market trends, ETFs make sense—prices change throughout the trading day to reflect current market values. Traditional mutual funds, on the other hand, are priced just once daily, at the close of the trading day.
But if you’re making frequent investments into a college fund or IRA account, a no-load mutual fund can be the way to go. It could help you avoid the trading commission you may be charged when buying and selling ETF shares.
And while ETFs and index funds may be smart options for your core portfolio, fundamentally weighted index ETFs and actively managed funds can be valuable complements for certain segments of the market.
Before you decide on the mix that’s right for you, let’s look at the benefits and potential drawbacks of each type of investment.
ETFs have been around for a little more than 20 years and have become extremely popular. As of October 2018, assets have grown to more than $3.48 trillion, according to the Investment Company Institute (ICI), an industry association.
ETFs trade like stocks and are primarily passive investments that 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 tend to have low annual operating expenses. Some charge as little as 0.03%. That’s a sizable advantage over actively managed funds that charge an average of 0.72%, according to Morningstar.1
ETFs are also generally more 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.
Consider investing in an ETF if:
- You trade actively.
Intraday trades, stop orders, limit orders, 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 tax sensitive.
Both ETFs and index mutual funds are more tax efficient than actively managed funds. In general, ETFs can even be more tax efficient than index funds.
Potential drawbacks of ETFs include:
- They give lower dividend yields.
As with mutual funds, the same reason that risks associated with owning an ETF are lower than with a stock or group of stocks mean the dividend yields are as well. This is because ETFs track a broader market so the overall yield is tied to an average.
- Some have larger bid/ask spread.
When you purchase or sell ETF shares, the price you are given may be less than the underlying value of the ETF’s holdings (the net asset value, or NAV). This discrepancy—called the bid/ask spread—is often minuscule, but for niche ETFs that don’t get a lot of trading activity, the spread can be wide.
- Watch out for fee creep.
Individual trading fees can add up quickly when you’re buying and selling ETFs, and that can reduce its performance. Be sure to explore what fees and commissions the provider charges for each trade.
Mutual funds are very popular among investors, with U.S. assets totaling nearly $18.66 trillion as of November 2018, according to the ICI—in large part because most workplace retirement plans, such as 401(k)s, offer mutual funds and not ETFs.
Mutual funds are generally bought directly from investment companies instead of other investors on an exchange. Unlike ETFs, they don’t have trading commissions, but they do carry an expense ratio and potentially other sales fees (or “loads”).
Like ETFs, index mutual funds are considered passive investments because they mirror an index. That means they can also be a low-cost way to invest—many have annual expenses of less than 0.10%.2
A few scenarios where an index fund may be a better option than an ETF:
- You invest on a frequent schedule.
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—a no-load fund can be more cost-effective. Using ETFs could cause you to incur a trading commission every time you make a periodic investment.
- 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.
As we covered earlier in the potential ETF drawbacks, you may have to consider the size of the bid/ask spread of a low-volume ETF before purchasing it. Mutual funds, by contrast, always trade at NAV without any bid-ask spreads.
An index fund's potential drawbacks are:
- It’ll never outpace the market.
Since index funds are tied to the performance of an index, they’ll never be able to beat a top-performing non-index fund. Index funds follow the tortoise’s “slow and steady wins the race” philosophy, and as a result can’t give you those thrilling short-term gains a non-index fund might.
- You have no control over holdings.
An index fund might not include a company or set of companies you like or believe will perform well. Conversely, companies you may not like might be included in an index. You have no control over the individual holdings in an index fund.
- You have no downside protection.
While an index fund like the S&P 500 has proven to be a relatively sound long-term investment, you are still at the mercy of the market. When the market takes a downturn, so does your index fund.
Actively managed mutual funds
The investments in an actively managed mutual fund are selected and managed by a portfolio manager (or multiple managers), who are often supported by a team of research analysts.
Active managers build a portfolio that reflects their strategy and outlook. For example, in rough markets, active managers can play defense by selling more speculative or risky assets and adding more conservative investments.
Actively managed funds are typically more expensive than ETFs or index funds—in large part, to compensate management.
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). Additionally, active management with a specific strategy may complement index funds in a portfolio. For example, some managers aim to reduce downside risk and volatility.
- You are investing in a less efficient part of the market.
Some markets are considered to be highly “efficient,” meaning the businesses or markets are so popular and information is so quickly and widely distributed that there isn’t much opportunity for active managers to add value. Large-cap U.S. stocks are an example of an efficient market segment. Emerging market stocks or high-yield bonds are less efficient markets where deep research and a proven strategy can likely pay off.
Potential drawbacks of an actively managed mutual fund to consider are:
- They could underperform vs an index.
This is the flipside of an actively managed funds’ potential to beat the market. There is also the potential that it can underperform vs the market.
- They generally have higher fees.
As the name would suggest, actively managed funds are, well, actively managed, and those managers will be taking their fee with every adjustment they make to the fund.
- They are generally less tax-efficient.
Actively managed funds tend to have a higher tax cost than index funds because as a manager liquidates and purchases investments in an attempt to beat the market, capital gains are realized more frequently and those are taxed. The more activity in a fund, the more those taxes add up.
1Morningstar’s April 2018 U.S. Fund Fee Study.
2According to Morningstar’s April 2018 U.S. Fund Fee Study, some asset managers now charge only a few basis points for core index funds.
What you can do next
Listen to a podcast that .
- Watch this video:
- Learn more about .
- Shop for Schwab .