Choosing between ETFs and mutual funds? 4 questions to help you decide
April 04, 2017
So you've got your investment plan in hand, your asset allocation set, and you're ready to go. But what next? Investing today comes with many decisions. For example, let's suppose that you decide to invest in an S&P 500 index fund. If you have to choose between an S&P 500 index ETF (exchange-traded fund) or S&P 500 index mutual fund, which would you choose? The right answer may not be so obvious.
If you said ETFs because you believe they're cheaper, or mutual funds because you think they're safer investment vehicles, you're not alone. There are a number of perceived differences between the two investment vehicles, but a majority of the differences boil down to how you buy and sell fund shares.
4 questions to help you decide between ETFs and mutual funds
- What is your investment strategy?
- How much trading flexibility do you need?
- How accessible are your fund options?
- Which fund is cost-effective?
"Probably the number-one misconception is that it's about ETFs versus mutual funds. We don't like to make it a 'versus' discussion because we don't think one is inherently better," said Jim Rowley, senior investment analyst for Vanguard Investment Strategy Group. "We offer both ETFs and mutual funds at Vanguard, and believe each can serve a purpose together in investors' portfolios."
Even in the areas where ETFs and mutual funds differ in terms of specific attributes, one could argue the most basic and compelling benefits stem largely from the benefits of the pooled investment structure and the shared regulatory environment that both are governed by.
"Both mutual funds and most ETFs are governed under the same regulatory standard, the U.S. Investment Company Act of 1940," said Mr. Rowley.*
So if they're more similar than different, how do you decide between an ETF or mutual fund? There are four key questions that can help you determine which one is better for your unique circumstances.
1. What is your investment strategy?
A good place to start is to determine what you're trying to accomplish with the ETF or mutual fund. The decision could be as simple as determining whether you're trying to invest in an index fund or an active fund.
From an investment strategy perspective, an overwhelming number of ETFs are indexed, and an overwhelming number of mutual funds are actively managed. So investors who are looking to index might prefer ETFs. Conversely, investors looking for actively managed investments may find mutual funds offer more choices to meet those needs.
2. How much trading flexibility do you want?
While the daily liquidity offered by mutual funds—once at the end of the trading day—is sufficient for many investors, ETFs offer greater control over timing and price. This is because ETFs can be traded throughout the day, just like stocks, when the market is open. Investors who specifically value this trading flexibility may find ETFs more appealing than mutual funds. Otherwise, this factor may not be a significant consideration for investors who don't want or need intraday liquidity.
3. How accessible are your fund options?
Depending on which brokerage account platform you're using, your options for purchasing a particular mutual fund can vary, and sometimes widely. This is because a mutual fund company must first enter into an agreement with broker-dealers to offer a company's funds on a brokerage platform.
In contrast, because ETFs trade on exchanges, just like stocks, they're more accessible. Any investor with a brokerage account can buy or sell virtually any ETF.
"It's not unlike the difference between purchasing a book from your local bookstore or going online. Your access is restricted by what's available on the store shelf. You might find more options online. There are tradeoffs to both options," said Mr. Rowley.
4. Which fund option is more cost-effective?
It's not uncommon to hear that cost should be the starting point for determining whether to go with an ETF or mutual fund, but we think this should be factored in only after you consider investment strategy, trading flexibility, and accessibility. Going through the decision process in this order can improve the likelihood that your decision matches up with your long-term investment goals.
There are various ways to determine whether ETFs or mutual funds are more advantageous from a cost perspective. ETFs and mutual funds are subject to two main types of costs, transaction and ongoing. It's not dissimilar from the decision to buy or rent furniture, which can involve a cost calculation that considers how you intend to use the furniture. Similarly, when choosing between a mutual fund and an ETF, consider more nuanced aspects such as ongoing and point-in-time transaction costs:
- Transaction costs occur at a point in time and include things such as bid-ask spreads and upfront fees or commissions. Vanguard ETFs® trade commission-free in a Vanguard Brokerage Account.
- Ongoing costs occur gradually over time and include things such as expense ratios and taxes.
Because of the nature of these costs, the expected holding period can make a big difference in determining which investment vehicle is more advantageous. For example, if the transaction costs for an ETF and a mutual fund are 0.20% and 0.10%, respectively, then the mutual fund would have a transaction cost advantage of 0.10%. If the expense ratios of the ETF and the mutual fund are 0.10% and 1.10%, respectively, then the ETF would have an expense ratio advantage of 1.00%. In this case, the break-even holding period is one-tenth of a year, or roughly five weeks. An investor whose expected holding period is greater than five weeks should choose the ETF because it will be more cost-effective after that period of time.
In addition, the decision whether to invest a lump sum or make ongoing investments may affect the choice between ETFs and mutual funds.
"If an investor is making regular investments in a fund, such as every two weeks or every month, then mutual funds may be a better choice, because mutual funds can generally facilitate automatic investment in a more efficient manner," Mr. Rowley said. "If, however, you're investing a lump sum, and intend to hold the investment for an extended period of time, then you might benefit from taking a closer look at the all-in costs to see which side of the breakeven point an ETF or mutual fund might fall on."
Key similarities can outweigh the differences
Choosing between ETFs and mutual funds may obscure an important point—these products are really more similar than different.
For investors who prefer a greater variety of index-based strategies, the ability to trade intraday with various order types, and more open fund access, ETFs may be the better choice. However, for investors who want a greater variety of traditional actively managed strategies, the trading convenience of mutual funds, and the breadth of mutual funds available on their trading platform, mutual funds may be preferable. Expenses include both ongoing costs and transaction costs, and may depend largely on the time horizon of the investment.
Making a choice between ETFs and mutual funds may require a test drive through the decision process. We have tools to help you. Both ETFs and mutual funds can help you achieve your investment goals and, in the end, you should be happy with what you drive off the lot.
*Mutual funds and most ETFs are regulated by the U.S. Investment Company Act of 1940, which requires funds to hold liquid assets, constrains the use of leverage, and provides transparency to investors through mandated prospectuses and annual reports.
- All investing is subject to risk, including the possible loss of the money you invest.
- Past performance is not a guarantee of future results.
- You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free) or through another broker (who may charge commissions). See the Vanguard Brokerage Services Commission and Fee Schedules on Vanguard.com for limits. Vanguard ETF Shares are not redeemable directly with the issuing Fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.