Are ETFs or mutual funds better? Depends

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Elliot Raphaelson

The last five years have been very good for diversified common-stock portfolios with mutual funds and exchange-traded funds (ETFs). The annual costs for both types of fund have never been lower. This has certainly made it easier for investors to have excellent results.

I can’t forecast the future, but I believe it is prudent (even for retirees) to maintain a significant percentage of one’s portfolio in common stocks, rebalancing regularly. (I like to rebalance annually.) Most investors will be better off with the majority of their stock investments in index funds, mutual funds or ETFs.

Why index funds tend to win

Readers who have managed accounts with annual fees of 1 percent or more often ask me if it would be better to buy low-cost index mutual funds or ETFs from one of the leading mutual fund companies or from a discount broker.

I never tell readers that paying 1 percent or more annually for actively managed funds is a mistake. But I point out that, in the long run, it is very difficult for managers to outperform low-cost mutual funds such as Vanguard’s Total Stock Market Index Fund Admiral Shares (VTSAX) or its Total Stock Market ETF (ARCA:VTI). Both have expense ratios of 0.05 percent (if you meet minimum investment requirements), so you’re starting out almost 1 percent ahead of managed funds.

I suggest that investors compare the past performance of their managed accounts to the long-term performance of index mutual funds or ETFs under consideration. The websites of all the major mutual funds have historical data you can access easily.

For example, the performance of Vanguard’s VTSAX follows:

Last year: 12.3 percent

Last three years: 16.39 percent

Last five years: 14.76 percent

Last ten years: 8.55 percent

The advent of ETFs has made it easier for investors to invest in diversified portfolios at low annual fees. For example, the average ETF expense ratio of Vanguard’s 67 ETFs is 0.13 percent. The industry’s average is 0.55 percent.

If you are interested in a specific index ETF, such as the S&P 500 index, it is easy for you to make a selection. If all other fees are the same, select the ETF with the lowest annual expense ratio.

What’s better for you depends

Although expense ratios are very important, there are other fees you to consider when you are selecting either a mutual fund or an ETF.

For example, if you are purchasing an ETF, are you incurring a brokerage fee for each transaction? Is there a bid-ask spread for each transaction?

If you are purchasing a mutual fund, is there a sales commission, or “load,” either front end or back end? Many good no-load mutual funds are available.

Under some circumstances, a mutual fund will be better for you than an ETF with the same annual expense ratio. For example, if you are investing each month, reinvesting all dividends and capital gains, using dollar-cost averaging can be more advantageous. If your alternative is an ETF, that would incur commission costs each month, as well as a spread between the bid and ask price, which means a mutual fund would be more cost-effective.

On the other hand, if you plan on using techniques such as stop losses, investing on margin, limit orders, or investing a smaller amount than you could with a mutual fund, then an ETF could be more advantageous.

Many investors avoid making their own selections and pay a manager an annual fee equal to 1 or 2 percent of assets invested. Unfortunately, it is not easy to outperform low-cost index funds or ETFs on a long-term basis. I hope your advisor has been outperforming the well-known indexes. I suggest you make the comparison yourself.

Fortunately, the growth of the ETF industry has led to lower overall costs for investors, and this has put pressure on mutual funds to maintain lower fund costs as well. It has made it easier for investors to have a wide selection of alternatives for index funds and other funds at lower costs.

And in the long run, minimizing costs is crucial to superior investment results.

Elliot Raphaelson welcomes your questions and comments at elliotraph@gmail.com.

© 2015 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.