Welcome to my blog where I discuss money, investing, politics, and anything else import in the world. I find it surprising that most people in their 30s have very little knowledge or interest in these areas. Of course everyone is interested in money, but very few take the time or have the discipline to properly save and invest it for the future or short term. For those who at least have the interest, I'll write about my experiences and methods of investing, and hopefully give you a head start in investing.

Monday, February 18, 2008

ETFs vs. Mutual Funds

Quick list in the difference between Exchange Traded Funds (ETFs) and Mutual Funds. If you listen to talk radio financial advice, you may have come across Ric Edelman, financial planner extraordinaire, who loves to bash mutual funds (since his last book came out). He, besides endlessly promoting himself, pushes ETFs instead. However, he is making an apples to oranges comparison. His main problem with mutual funds are with actively managed funds, while ETFs are index based funds, so it is more proper to compare ETFs to index mutual funds. So if you believe in the philosophy of investing for the long term by indexing, I think both options are equally good. Main differences:
  • ETFs are traded throughout the day on the stock market, Mutual Funds are only bought at the close of the market. For the long term, this is not a major issue, as you can more precisely buy and sell and ETF using limit or stop orders, however with mutual funds you need to check the index performance and decide to buy or sell just prior to market close. If you are dollar cost averaging and investing for the long term, daily market swings are unlikely to cause a major difference in performance. Slight advantage to ETFs.
  • ETF transactions incur a broker commission. Index mutual funds have no transaction costs. Ultra low cost brokers do exist, so this can be somewhat mitigated, but for dollar cost averaging, ETFs will cost a little more. Slight advantage to mutual funds.
  • Expense ratios for each are very low. ETFs are typically slightly lower. For example, at the moment VTI (the total stock market ETF) vs. VTSMX (the total stock market mutual fund) is .07% vs .19%. Both are very low compared to actively managed funds that can be 2% or more. To see what this means for performance, I compared the total performance of each over the last 5 years. Currently they are almost identical, VTI is up 69.5%, versus 69.7% for VTSMX. So the mutual fund actually did better. This comparison will vary based on what indexes you are using and which mutual fund product.
  • Tax advantage is really none. Both should have minimal distributions, since there is low turnover, and both will generate income from dividends. Capital gains are handled the same.
  • Minimum investments for ETFs are one share. Often mutual funds require a few thousand dollars to open the account and then some small amount per transaction ($50 or $100). This is an advantage for ETFs for the very small investor just starting out.
  • ETFs can be shorted and Options are available, so calls and puts can be used. Mutual Funds cannot do this. So for the very active trader, ETFs are a much more sophisticated product.

While ETFs and index mutual funds are quite similar, there are some advantages to each. For the long term passive investor, either will serve you well. If you are currently invested in quality index mutual funds, there is no advantage to transferring that to ETFs. If you want ultimate control and have a very low cost broker, ETFs are probably better, but don't be scared away from mutual funds. No matter which you choose, what is ultimately important is your asset allocation, and low expenses. Research has shown those factors to far outweigh market timing techniques over the long term.

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