ETFs vs. Mutual Funds: The Long and Short (Term) Of It

Exchange-traded funds, commonly known as ETFs, are gaining an increasing amount of popularity among investors as an alternative to traditional mutual funds. ETFs have the advantage that they trade directly on major stock exchanges like common stocks. This guarantees a high level of liquidity to move in and out of ETFs at will. The drawback of ETFs is that they generally track an index or industry of stocks, and are not actively managed like a mutual fund. This lack of rebalancing makes ETFs better investments in the short-run, but mutual funds remain a smarter option for a longer time horizon.

The most common ETFs directly track the major stock market indexes like the Dow Jones Industrial Average, Nasdaq, or S&P 500. Arguably the most popular ETF is the Nasdaq-100 (QQQQ) which tracks the 100 largest stocks trading on the Nasdaq. The average daily volume on the Q’s is usually over 120 million shares. The Dow Jones Industrial Average can be tracked with the Diamonds (DIA) ETF and the S&P 500 by the S&P Depository Receipts (SPY).

Recently a fancier group of ETFs were released that provide twice the performance of major indexes. For example, the Ultra Dow30 (DDM) offered through the ProShares family of funds will theoretically increase 2% in value when the Dow increases by 1%. This type of leverage is a boon for confident investors in times of high margin interest rates.

Another advantage of ETFs is that if you feel a particular index or industry is due for a decline, you can short-sell the issue and profit if the ETF falls. ProShares also has a line of UltraShort index and sector funds that can be viewed here.

Not all ETFs track stock market indexes though – some follow the price of commodities like crude oil (USO), gold (GLD), and silver (SLV), while others track individual sectors like energy (XLE), semiconductors (SMH), and real estate (ICF). These funds should be researched thoroughly before investing because they can involve serious pitfalls. The U.S. Oil Fund (USO) is supposed to follow the price of West Texas Intermediate Crude Oil, but is currently trading about $10 a share lower than the price of the actual commodity due to high costs incurred while trading oil futures contracts.

While ETF’s are great instruments for generating returns and achieving diversification in the short-term, mutual fund investing can pay off over longer periods of time. The fee structure for ETFs and Mutual Funds vary slightly. For ETFs, the fees involved are stock commissions and an expense ratio which is usually around 1% and factored into the share price.

Mutual funds have a more complicated and varied fee structure. Some funds charge a “load fee” which serves as a percentage commission for each purchase you make, a flat transaction fee, an expense ratio, and a redemption fee if you liquidate your position within a certain timeframe.

There are many mutual funds that offer no-load and no-transaction fees, and if you hold the fund longer than the redemption period you can avoid all fees except the expense ratio. Another consideration when investing in mutual funds is that most impose a minimum investment that must be met.

The active management of mutual funds serves to usually provide superior returns that outperform the market averages. Some things to consider when choosing mutual funds are the fees and expenses charged by the fund, analyzing the consistency of past returns, and what the current top holdings of the fund are.

With so many ETF and mutual fund options available, researching various funds and finding what fits your portfolio best is vital. Financial institutions have large incentives for throwing out whatever new type of ETF they can think of to feed investor appetite. Retirement accounts that aren’t actively managed should be invested in a basket of mutual funds, and ETFs used primarily for shorter-term diversification.

Comments

[Panskeptic:]

Is it just me, or is the case for long term holding of mutual funds not made here? Even if all fees are waved besides expenses, many mutual funds have higher running costs than ETFs.

The only plus I can see with mutual funds is for dollar-cost averaging in small accounts, where many tiny purchases could cause brokerage commissions to add up, but if the article includes that benefit I missed it.

And this quote, "The active management of mutual funds serves to usually provide superior returns that outperform the market averages." is not something we will all agree on.

Perhaps the word "usually" can be replaced with "theoretically."

2007 Apr 19 09:55 AM

[ej76az:]

Preposterous Statement Number One: "The active management of mutual funds serves to usually provide superior returns that outperform the market averages." Actually, no actively managed mututal fund has ever outperformeded its corresponding index over the long term, and even in the short term the overwhelming majority of actively managed mutual funds underperform their corresponding indexes.

Preposterous Statement Number Two: "While ETF’s [sic] are great instruments for generating returns and achieving diversification in the short-term, mutual fund investing can pay off over longer periods of time." Actually, ETFs have lower expenses than index mutual funds and therefore are cheaper over time, assuming you're not paying high commissions. Vanguard's website allows you to compare any mutual fund to any ETF over any time period.

2007 Apr 19 02:00 PM

[MDCigan:]

<i>Actually, no actively managed mututal fund has ever outperformeded its corresponding index over the long term,</i>

This is completely inaccurate. There are plenty of funds that have outperformed over the long-term. Sequoia, Longleaf, Legg Mason Value Trust, etc.

2007 Apr 20 06:19 AM

[ej76az:]

Perhaps I should have said almost none. Backtesting and data mining can usually produce outliers, so I suppose if one looks hard enough one could find some tiny number of actively managed funds that outperformed their corresponding indexes, even over the long term.

I had never heard of any of the 3 funds you named. The Sequoia website is not functioning. The Legg Mason Value Trust website describes the fund as large-cap value, and the Longleaf Partners Fund website describes the fund as large- and mid-cap value. Nevertheless, both websites compare the funds to the S&amp;P 500 Index, which is totally misleading. The long-term performance of each of these funds is comparable to that of the large-cap value index, which, as most people know, has outperformed the large cap (i.e. S&amp;P 500) index.

In any event, there is no proven methodology for determining which actively managed mutual funds will outperform their corresponding indexes in the future. All studies of past performance show no correlation with subsequent performance (e.g., the few actively managed funds that outperformed their corresponding indexes from 1980-1990 did not do so from 1990-2000). Therefore there's no rational way to choose any actively managed fund over its corresponding index fund.

2007 Apr 21 04:05 PM