Financial cage match: ETFs versus mutual funds

Homemade Enigma machine

I want everyone to be an investing expert. Thankfully, I also believe that simplicity in investing is best. Create a Roth IRA, put money into low-cost index funds, and repeat this every month.

When I say “low-cost index funds”, I’m talking about a special class of mutual funds. These are no-load, passive funds, designed to track a collection of companies. One of the most famous collections is the S&P 500, which is based on the market capitalizations of 500 large companies in the U.S.

But if you wanted to buy into a fund that tracked the S&P 500, there is more than one way to do it.

What I’ve always talked about is buying mutual funds. A mutual fund is defined as:

[A] type of investment company that pools money from many investors and invests the money in stocks, bonds, money-market instruments, other securities, or even cash.

But there is another investment vehicle that allows you to purchase the exact same kind of securities, but in a different way. They are called “exchange-traded funds” or ETFs.

I can give you the official definition of what an ETF is, but I’ll warn you, it’s pretty opaque.

The more important question is: do you invest in mutual funds or ETFs? Or both?

It’s time for another financial cage match!

Let’s compare

I think it’s easiest to describe what an ETF is by comparing them to mutual funds. Tellingly, it’s not easy to find a good comparison of ETFs versus mutual funds. I’ve found Vanguard has a good run down of the differences, but I’ll summarize even further.

(For this comparison, I’m going to assume that we’re talking about investing while inside a tax-advantaged account such as an IRA. There are other considerations in other cases, but I’m going to be ignoring them.)

In general, you can buy either in the same way: you can purchase a mutual fund in the same way as you do an ETF. However, as ETFs are traded like stocks, you buy “shares” of ETFs, whereas you put money into a mutual fund. A subtle difference, but a real one.

Here are some more differences:

  1. Unlike mutual funds, ETFs act like stocks, in that their value will change over the course of the day, while mutual funds are priced once a day.
  2. Mutual funds require a minimum investment, usually $1,000 or higher. ETFs have no such requirement. You can buy one “share” of an ETF if you want.
  3. ETFs can sometimes have lower fees than their equivalent mutual fund.
  4. You can set up an automatic investment plan with a mutual fund. No dice with ETFs.
  5. It’s free to convert mutual funds to ETFs, but I’ve read some conflicting reports about the reverse.
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Let’s score

Let’s take these one at a time.

  1. Remember, we’re only talking about retirement accounts here, and no one here is going to be day trading, so it doesn’t matter when the value changes over the course of a day. We’re buying and holding for the long term, and there is no difference there. Result: Tie
  2. Being able to invest with less money is a good thing, though given the amounts we’re all going to need, $1,000 can’t really be considered too high a bar. Slight advantage: ETFs
  3. Lower fees are certainly better than higher fees, especially when everything else is equivalent. Take the example of the Vanguard 500, which is available in three formats: Investor shares (VFINX), Admiral shares (VFIAX), and an ETF (VOO). The Investor shares have a 0.16% fee, while both the Admiral shares and ETF have a 0.05% fee. Admiral shares require a $10,000 minimum balance, so if you don’t have $10,000, you can save a little bit of money going with ETFs over mutual funds. Slight advantage: ETFs
  4. I’m a huge fan of automatic investment plans, as I don’t like to pay bills. With my own Roth IRA, I set up an investment plan in January for the entire year. Then I forget about it. Advantage: Mutual funds
  5. I think this is a tie, as the tax liabilities from converting from ETFs to mutual funds appear to be non-existent for retirement accounts. But just to be on the safe side, I’m going to abstain from a ruling here, pending further research.

Who wins?

You might see this as a toss-up, and in many ways, you’d be right.

But there are extra reasons which tip the balance.

Notice that the benefits of ETFs only apply to those with small balances. As your balances grow (and they’re going to, right?) the differences become moot. And since at least Vanguard will automatically convert Investor shares to Admiral shares, if you start out in a mutual fund, you won’t need to do any conversion later to get the lower fees. And you can set up an automatic investment plan today.

So I would suggest investing in mutual funds over ETFs.

If you have less than $1,000, then just use a savings account (or a cookie jar) and sock away money until you have enough to buy into a mutual fund. Believe me, the interest you’re going to get on your first $1,000 is minimal, so you’re not foregoing much of anything.

ETFs aren’t bad, and if you have some I wouldn’t recommend selling them or anything. But I think over the long term, the benefits of mutual funds (specifically index funds) outweigh any advantage that ETFs have. When in doubt, pick the five letter code.

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But enough about me: Do you invest in ETFs? What do you think about them?

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