Should I Invest in a Mutual Fund or an Exchange Traded Fund (ETF)?

The answer to this question depends on what you want to do. Start with a decision regarding what you want to own. Do you simply want to buy some US stocks, or some bonds, or even real estate? Of course, whatever you buy, you’ll want the “best”, but do you know what that means? And how does the investment fit into your overall portfolio? Are you diversifying current holdings or adding to existing positions? In other words, there’s a mosaic, a puzzle, that you need to consider.

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Once you’ve established the reason for buying a mutual fund or Exchange Traded Fund (ETF), you can decide which is the better choice. If you want a passive allocation, buying the entire market, like the S&P 500, an ETF is probably your better choice because ETFs are designed to track markets or market segments, they trade like stocks, are generally lower cost, and have tax benefits. But you won’t get the “best security”; you’ll get all of the securities in the Fund.

If you want the “best” securities, you’ll want a mutual fund, but there are no guarantees you’ll get the best. You’ll get whatever the fund’s manager selects on your behalf. This is called “active” management. The manager’s objective is to pick securities that perform better than other securities in the asset class you choose. There are a lot of smart people competing with each other in mutual funds to pick the best. Ironically, these really smart guys generally fail as a group. In fact their collective efforts keep markets “efficient”, which means stock prices are fair. In a very real way, passive managers ride on the backs of these active managers, earning average returns. Bottom line, paying the higher fees for a mutual fund should only be done if you’re confident you can find a good one, worth the additional expense.

These decisions are rarely black or white. Active-passive is a popular approach originally put forward by Dr. Frank Sortino. In this framework, you use “good” active mutual fund managers whenever you can find them. “Skill” is the word usually used to describe good managers, but that word is hard to define. However defined, skill is hard to find, so you want to buy it when and where you can find it. But if you stopped there, you would probably not be diversified, with reasonable allocations to all segments of the markets – stocks, bond, real estate, etc.

That’s where passive ETFs come in.  You buy passive ETFs for segments of the markets where you cannot find skillful managers. In the case where you can’t find any skillful managers, or you don’t know how to find them, you would use all passive ETFs.

Some professional money managers create and market funds-of-funds, which are portfolios of mutual funds and ETFs. These come in all flavors. Some are comprised entirely of mutual funds, while others are entirely ETFs, and yet others are blends of mutual funds and ETFs. Knowing the make-up of these funds is a strong clue to the manager’s confidence in their ability to identify skill. Also, some attempt to add value through market timing, that is changing allocations over time. In the hierarchy of what matters, asset allocation is king, so the mix of mutual funds and ETFs doesn’t matter nearly as much as the allocations through time.

There are other considerations. In some cases, the approach you want to buy is only available as a mutual fund or ETF. For example, there are hedge fund replication approaches that are only available as a mutual fund. As a general rule, the mutual fund structure has more flexibility than the ETF structure, and there are a lot more mutual funds, so if you’re looking for something extraordinary you’re more likely to find it in a mutual fund.