Debates regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs) are common in the investment community. Mutual funds and ETFs have benefits and drawbacks. Though ETFs offer market-based trading and typically lower expense ratios, investors may choose mutual funds over ETFs for several reasons.
Key Takeaways
- Mutual funds are an established investment vehicle, but ETFs have gained popularity.
- Some mutual funds are actively managed and have some risk due to leverage but limit the amount that can be used.
- ETFs are generally less expensive than mutual funds but with less management and reduced services.
Strategy and Risk Tolerance
Mutual funds are available for all different types of investment strategies, risk tolerance levels, and asset types. ETFs can be limiting as they are mostly passively managed indexed funds that invest in the same securities and mirror the chosen index.
Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.
Investing in mutual funds allows investors to choose a product that suits their risk tolerance levels and meets specific investment goals, such as dividend income or retirement planning.
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Active Management Without Leverage Risk
By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate a multiple of an index's returns. While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility.
Mutual funds are strictly limited regarding the amount of leverage they can use. Mutual funds can borrow capital, but they must ensure that they have "an asset coverage of at least 300 percentum," or only one-third of the total value of a fund. Mutual funds offer many combinations of security and risk to investors.
Individuals can choose mutual funds that focus on long-term capital gains that primarily invest in proven growth stocks but also look to benefit from early identification of up-and-coming businesses poised for exponential growth. The tried-and-tested stocks form a solid basis for long-term gains, while investments in newer or undervalued stocks provide the potential for rapid growth in exchange for a certain degree of risk.
Automatic Investment and Customer Service
Mutual funds offer automatic investment plans and ETFs do not. These services facilitate regular contributions and allow investors a consistent way to grow their investments, especially for retirement. The practice of investing a set amount each month allows for dollar-cost averaging, where investors pay less per share over time by purchasing more shares with the same amount of money in months when the share price is low.
Unlike ETFs, mutual funds can be purchased in fractional shares or fixed dollar amounts.
ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be slightly more costly, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer check-writing options and other shareholder services that ETFs don't provide.
Dividend reinvestment plans (DRIPs) take the stress of decision-making by automatically converting dividend distributions into investment growth.
How Are Mutual Funds Priced?
Mutual funds always trade at Net Asset Value (NAV). Mutual fund orders are executed once daily and all investors receive the same price.
Do Mutual Funds Have Minimum Investment Requirements?
Most mutual funds require a minimum initial investment based on a flat dollar amount.
How Are Mutual Fund Investors Taxed?
When a mutual fund sells securities in the fund, it may trigger capital gains for shareholders, even for those with an unrealized loss on the total mutual fund investment. Investors are liable for taxes on the capital gains earned.
The Bottom Line
Both mutual funds and ETFs can be smart investment choices, and many investors may choose both. However, there are some clear reasons why mutual funds may be the better choice for an investor's goals and strategy, such as those that want periodic investment or a wide variety of fund options.
