Investors looking for diversification 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 specific market niche, without having to buy scores of individual securities.
The challenge however, lies in narrowing down your options. Do you choose an ETF that tracks an index, such as the S&P 500® Index—or a low-cost index mutual fund that does the same? Or perhaps a ETF that may improve a portfolio’s overall risk-adjusted performance? Or maybe a mutual fund with stellar management?
The answer depends on your goals and needs. 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 trade like stocks and are primarily passive investments that seek to replicate the performance of a particular index (although actively managed ETFs are also available).
A passive management style often results in lower expense ratios than those charged by actively managed funds. Some passive ETFs charge less than 0.05%, with some even charging 0.00%. That’s a sizeable advantage over actively managed funds that charge an average of 0.67%, according to Morningstar.1
Passive ETFs also tend to be tax efficient, in part because tracking an index usually doesn’t require frequent trading, and ETFs have a structural ability to minimize the capital gains they have to distribute. Historically, investing in ETFs has meant paying trading commissions every time ETF shares were bought or sold, but at Schwab and several other brokerages, ETFs now trade commission-free2.
Consider investing in an ETF if:
- You trade actively.
Intraday trades, and 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 want tax-efficiency.
Both ETFs and index mutual funds are more tax efficient than actively managed funds. In general, ETFs can be even more tax efficient than index funds.
Potential drawbacks in an ETF include:
- Some have large bid/ask spreads.
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.
Some ETFs use fee waivers to temporarily offer lower expense ratios to investors (termed the “net expense ratio”). Although these waivers are often extended, the fund sponsor may decide to allow the waiver to expire. If that’s the case, the expense ratio will increase from the “net” amount to a higher “gross” amount. Investors can find the net, gross and fee waiver expiration date (if applicable) in the ETF’s prospectus.
Mutual funds are generally bought directly from investment companies instead of from 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”).
Index mutual funds
Like ETFs, index mutual funds are considered passive investments because they mirror an index. They can also be a low-cost way to invest—many have annual expenses of less than 0.10%. 3
A few scenarios where an index fund may be a better option than an ETF:
- 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.
- 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 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 actively managed 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 an actively managed 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 could outperform 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 could pay off.
Potential drawbacks of an actively managed mutual fund are:
- They could underperform the market. This is the flipside of an actively managed funds’ potential to beat the market. There is also the potential that it can underperform versus the market.
- They tend to 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.
2 The standard online $0 commission does not apply to large block transactions requiring special handling, restricted stock transactions, trades placed directly on a foreign exchange, transaction-fee mutual funds, futures, or fixed income investments. Options trades will be subject to the standard $.65 per-contract fee. Service charges apply for trades placed through a broker ($25) or by automated phone ($5). Exchange process, ADR, foreign transaction fees for trades placed on the US OTC market, and Stock Borrow fees still apply. See the Charles Schwab Pricing Guide for Individual Investors for full fee and commission schedules. Multiple leg options strategies will involve multiple per-contract fees.
3According to Morningstar’s April 2018 U.S. Fund Fee Study, some asset managers now charge only a few basis points for core index funds.