ETFs Versus Mutual Funds: What is the Better Option?

What is a mutual fund?

Mutual funds are collections of securities, such as stocks, bonds, commodities, or currencies, that are managed by a professional fund manager. Mutual funds can be either actively or passively managed.

According to a report by Morningstar, the total assets under management (AUM) of ETFs and mutual funds in the U.S. reached $35.7 trillion and $24.9 trillion, respectively, as of September 2023. However, ETFs saw a 30.6% increase in AUM year-over-year, while mutual funds saw a 14.9% increase.

Fees and expenses

Important factors to consider when choosing between ETFs and mutual funds are their fees and expenses.

Fees and expenses are measured by the expense ratio. This is the percentage of the fund's assets that are deducted annually to cover the fund's operating costs. Operating costs include portfolio management, administration, marketing, distribution, and other expenses. The expense ratio is usually expressed as a percentage, such as 0.5% or 0.05%.

The average expense ratio for ETFs is typically lower than the average expense ratio for mutual funds. This is because ETFs are usually passively managed, meaning they track an index or a basket of securities, and have lower portfolio turnover, trading costs, and research expenses. Mutual funds are usually actively managed. They try to beat the market by selecting and trading securities, and have higher portfolio turnover, trading costs, and research expenses.

According to a report by Morningstar, the average expense ratio for index ETFs was 0.18% in 2020, while the average expense ratio for index mutual funds was 0.57%. The average expense ratio for actively managed ETFs was 0.55%, while the average expense ratio for actively managed mutual funds was 0.66%. This means that ETFs can save investors up to 0.39% to 0.11% per year in fees and expenses, compared to mutual funds.

To illustrate this difference, let's assume that an investor invests $10,000 in an index ETF and an index mutual fund that both track the S&P 500, which has an average annual return of 10% over the past 10 years. The index ETF has an expense ratio of 0.18%, while the index mutual fund has an expense ratio of 0.57%. After 10 years, the index ETF would grow to $24,433, while the index mutual fund would grow to $22,705. The difference of $1,728 is the amount that the investor would lose in fees and expenses by choosing the mutual fund over the ETF.

Diversification and customization options

Diversification is the process of spreading your money among a variety of different investments in an effort to reduce risk and improve returns. Diversification can be achieved across asset classes, such as stocks, bonds, commodities, or currencies, or within asset classes, such as large-cap, small-cap, value, or growth stocks. Diversification can help investors reduce the impact of market fluctuations, as different investments may react differently to events and factors.

Customization is the process of tailoring your portfolio to match your specific preferences, goals, and needs. Customization can be achieved by selecting investments that align with your risk tolerance, time horizon, budget, or values. Customization can help investors achieve their desired outcomes, as different investments may offer different levels of return, income, growth, or impact.

Both ETFs and mutual funds offer investors a wide range of options to diversify and customize their portfolios and access various markets and sectors. However, ETFs may have an edge over mutual funds in terms of customization and specialization, while mutual funds may have an edge over ETFs in terms of diversification and risk management.

Customization and specialization

ETFs are known for their ability to offer more customization and specialization options than mutual funds, as they offer more niche and thematic products that cater to specific investor preferences and goals. For example, there are ETFs that focus on environmental, social, and governance (ESG) factors, cryptocurrencies, artificial intelligence, or cannabis. These ETFs allow investors to express their views and values, or to capitalize on emerging trends and opportunities, in a convenient and cost-effective way.

However, customization and specialization also come with some drawbacks, such as higher fees, lower liquidity, and higher risk. Thematic ETFs tend to have higher expense ratios than broad-market ETFs, as they incur more costs for research, marketing, and management. Thematic ETFs also tend to have lower trading volumes and wider bid-ask spreads than broad-market ETFs, as they have less demand and supply in the market. Thematic ETFs also tend to have higher volatility and lower diversification than broad-market ETFs, as they are more exposed to specific sectors, regions, or factors that may experience rapid changes or shocks.