Are ETF’s as Effective as Mutual Funds?

by Will Lipovsky · 4 comments

time is money
ETF’s enable people to enter markets that otherwise would be out of reach. Using inverse ETF’s and ETF’s that track gold and other commodities, retail investors and traders now have an effective way to diversify their portfolio.

The most popular ETF, the SPY, tracks the S&P 500 and is used for trading and short term investing. Is it possible that an ETF is as effective as a mutual fund? Buying and holding securities for long periods of time is the tried and true method, and we’ll use that theory for comparison purposes.

Mutual funds are the go-to investment for the average 401k contributor. Commonly, there are four categories that include aggressive growth, moderate, conservative, and international funds. Built for long-term investments, these tend to see healthy returns over long periods of time. On the other hand we have short-term investment vehicles, which are ETF’s that offer safe and effective ways for investors to enter and exit trades quickly. For example purposes, let us use the SPY and compare it against the Vanguard 500 Index Fund Investor Shares (VFINX).

These two examples are similar in nature because they are tracking the S&P 500, or “the market”.

Retail investors commonly view expense ratios. Comparing the two, the SPY comes in with an expense ratio of .11% while the VFINX is .16%. Year to date, VFINX is at 7.72% growth and SPY is at 7.73%.  The issue of liquidity may arise, but with these particular two examples, one need not worry about liquidity. This issue is more prevalent with ETF’s that follow non-traditional commodities such as coffee or cotton.

Editor’s Note: Most of you already know this, but it’s worth noting that Vanguard also offers the Admiral class shares of the S&P 500 fund with ticker symbol VFIAX. This fund has a $10,000 minimum investment requirement, but it charges an expense ratio of .05% with a year to date performance that’s higher than SPY.

Psychology may be the topic that differentiates these two products. Proven time and time again, it is more effective to hold your investments no matter how the market moves. During the 2008 financial crisis, it negatively affected performance to pull dollars out of investments. Fast-forward a few years; the market is past pre 2008 highs and now pursuing all time highs.

Some ETF’s are highly liquid if you ever need to liquidate your position. Inversely, they create an irresistible temptation to jump in and out of the market. Mutual funds appear less tempting to exit as you might have fees or other restrictions for exiting the fund. One item to note, while an investor can buy one share of SPY, the VFINX requires a $3,000 minimum to join the fund. Each fund may carry their own individualized requirements so be sure to read the details.

Another note worthy aspect of ETF’s mentioned in the introduction is the exposure to other aspects of the market that mutual funds may not offer, specifically inverse ETF’s and commodity ETF’s. Yes, there are inverse mutual funds, but long-term investment in a market downturn would not be a wise investment according to popular opinion. Using high liquidity inverse ETF’s allow you to hedge against short-term market downtrends while maintaining a long overall position. Entering commodity ETF’s for trades on large news events or natural events such as a warm winter also can help the retail investor diversify and take advantage of great opportunities.

Editor’s Note: Let me just warn everyone again that buying inverse ETFs or other exotic investments isn’t in the best interest of pretty much everyone in the market. We here at advocate indexing, because it works and you won’t have to quit your job to monitor the investments long term. There are many investment products and many of them are complex. There are tons of people who claim to make money with all kinds of stuff, but most people don’t understand enough before they jump in and they cannot adequately assess the situation when an investment turns against them. If you really want to get into complex strategies, then just be careful.

Are ETF’s more effective than mutual funds? The answer is not black and white. If you can hold onto either the mutual funds and ETF’s through the thick or thin, there are little differences. However, ETF’s offer flexibility to enter and exit positions with ease and there are no fund requirements except to have enough cash to buy the desired number of shares. This is an advantage but it can end up hurting investors because it’s too easy to abandon course.

In the end, though, it comes down to personal preference. The SPY will mimic the market very well, but the discipline is to hold the asset during rough market periods. Being invested in a fund may be equally as safe, and its potential restrictions will help with keeping funds invested. Always be sure to conduct your own research and consult an investing professional if you are unsure where to begin.

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  • Mick says:

    A huge overlooked aspect here is tax efficiency!
    Due to the difference in tax treatment, ETFs are highly tax efficient while mutual funds pass tax liability for all income and capital gains directly to the investor.

    • David @ says:

      What you are seeing is probably because many ETFs are passively managed while mutual funds are actively managed. I own the Vanguard Total Stock Market Index Mutual Fund and they haven’t had a capital gains distribution in many years.

  • Alexander @ Cash Flow Diaries says:

    Late last year I took the plunge and bought my first ETF. It has since doubled which is great but its super volatile. Its a gold mining ETF and its been one heck of a ride so far but I really like how easy it is to buy and sell. I personally like ETFs better.

    • David @ says:

      Doubling in a year is awesome – you timed the ETF perfectly. Have you considered selling even though it’ll cost a lot in taxes? You already won this bet, so you can lock in your gains by selling and move the money towards a more balanced portfolio that will be successful in the long term.

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