If you are investing in stocks, then hopefully you have already learned about the importance of having a diversified portfolio. If not, never fear because I’ll cover that a little in this article. ETFs (Exchange Traded Funds) and Mutual Funds offer the benefit of diversification and can be used to balance your portfolio to protect it from a single event in the stock market destroying all the hard work you put into your investments. So, are ETFs better than mutual funds? That’s what we’re about to explore!
What’s a Mutual Fund?
A mutual fund basically collects money from numerous investors into a pool and uses that collected money to buy stocks and manage them for the investors. Some mutual funds have between 10 to 30 different assets in their portfolio while some even have 100 or more. The benefit to a mutual fund is that it is generally diversified.
If you own 3 stock equities and invest $1000 in each of them, what would happen if really bad news hit one of your three assets? Let’s say you took a 30% drop in one of the equities because of “bad news.” That would be a drop of $300 from your $1000 or 10% of the overall portfolio since you only had three equities.
Now if you had your money invested in a mutual fund that had 100 different assets and one of the equities in the fund dropped 30%. If the fund was perfectly balanced and weighted the same, you would effectively have your $3000 split up 100 different ways so each equity would only be worth $30. A 30% drop of $30 is only $9 or 0.003% of your whole portfolio.
Now that’s powerful! Having a diversified portfolio protects you from those types of events.
What’s the Downside to Mutual Funds?
Well at first glance, mutual funds sound great. In some ways, they are. I want to make sure you know the whole picture before you throw all of your money in a mutual fund and sit back waiting for the magic to happen.
First of all, mutual funds are managed funds by a fund manager and in some cases, a team of professionals. Do they work for free? Of course not. A typical mutual fund charges between 1 to 3% of the value of fund in order to cover administration fees, management fees, expense fees, and marketing fees. If you’ve invested $3000, at 1.5% you will pay $45/year.
Obviously if the fund performs well and your portfolio goes up in value, that dollar amount will rise too. Obviously, fund managers will do their best to ensure your portfolio performs well in the market. Their job depends on it after all. Even if you make 9% that year, before you see that 9%, you’ll give up your 1.5% thus bringing your performance down to 7.5%.
So What are ETFs?
Exchange Traded Funds (ETFs) are a security that tracks either an index, a group of assets/equities, or a commodity and can be traded on the market similar to stocks. An example of this would be the S&P 500 ETF known as SPY. S&P 500 is a collection of the top 500 companies on the American Stock Exchange by market value. By owning shares of SPY, you own part of not one company, but 500 companies.
Some ETFs are industry based. For example IHI is an ETF I hold that is a collection of pharmaceutical and medical stocks. If you feel like you have too much invested in one specific industry, you can use other industry ETFs to balance out your portfolio. Vanguard is the largest provider for Mutual Funds and the second largest provider of ETFs.
ETF’s Vs Mutual Funds
Now that we’ve defined the two different types of funds, lets go over what makes them different.
Mutual Funds are designed to be liquid in nature. Typically, if you want to withdraw from a Mutual Fund, you can contact your Fund Manager and the money can be pulled out in a day or two on average. ETFs are traded openly using stock tickers so you can place a sell order and be out of the ETF in minutes.
Mutual Funds generally have a minimum amount of investment capital to get started. Some places require $2500 to get started while others may charge more or less. ETFs can be traded anywhere you trade stocks so you only need enough money to cover the share price. For example, SPY is about $250/share at the writing of this post. If you $250, you can buy 1 share (not counting the cost of trade commissions).
Speaking of trade commissions, you may have to pay them for ETFs depending on your broker. Some brokers will not charge trade commissions but most do. Trade commissions range from $4.95/trade to $20/trade although I don’t know why anyone would be in a broker that charges $20/trade. Robinhood for example charges no trade fees ever. Now if you buy 50 shares vs 1 share, the trade commission is the same. So if you buy 1 share of SPY ($250) or 10 shares ($2500), the commission doesn’t change. Mutual funds don’t typically have these although they may have what’s known as a load fee which is very similar.
Expense Ratios are expenses that are charged by the fund to cover administration costs, marketing costs, and general operation of the fund. This is where I think you’ll see the beauty of ETFs. A mutual fund like I mentioned above usually has an expense ratio of 1-3% A typical ETF has an expense ratio of 0.07% on average! This makes a huge difference but to put it in perspective, here’s another example. A Mutual Fund that made 9% one year would really earn your account 7.5% after taking account the 1.5% expense ratio. An ETF that made 9% would leave you with 8.93%. I can live with that!
Final Take Away
ETFs offer more flexibility than Mutual Funds. ETFs have way fewer fees which means a lot of money left in your account each year to continue earning you more returns for every year to follow. Some IRAs and 401k use Mutual Funds and so I think they still have their place in investing. If you are actively managing a portfolio though, I don’t know why you’d ever choose a Mutual Fund over an ETF.
I hope you found this interesting. As always, if you know someone that can benefit from this information, please share this page with them. If you have any questions or comments, I’d love to hear from you below.
As always, let’s start investing!