It's virtually impossible to hand-select a diversified portfolio on your own. But diversification is risk management 101. You don't want your life's savings to depend solely on the performance of a couple of stocks you've cherrypicked.
Fortunately, mutual funds and exchange-traded funds offer an easy shortcut. Both can make you an automatic investor in a huge bucket of securities. That instant diversification makes mutual funds and ETFs less risky compared to single stocks, bonds, and other investments. The drawback, of course, is that you don't get the potential for huge gains that you do with a winning stock.
Similarities aside, when you compare ETFs versus mutual funds, ETFs are often the clear winner. Here are five reasons to bid adieu to mutual funds and invest in ETFs instead.
1. Passive management beats active management
Most mutual funds are actively managed, which means a human makes investment decisions and tries to outperform a market index.
But the vast majority of ETFs are passively managed index funds, which means less human involvement. The fund is designed to deliver returns that match a benchmark index, like the S&P 500. The manager's job is simply to ensure that the fund's investments mirror the underlying index.
While having a human making decisions sounds like an advantage, that's typically not the case. When you compare active versus passive management results, you'll see that actively managed funds tend to underperform after you account for fees.
2. ETFs have lower fees on average
About those fees: Human management doesn't come cheap.
Actively managed funds have higher expense ratios compared to passively managed funds. The higher the expense ratio, the more of your money is going to fees versus the actual investment. As a result, ETFs usually have lower fees than mutual funds.
Morningstar's 2019 Annual Fund Fee Study found that actively managed funds had an average expense ratio of 0.66%. For passively managed funds, the average was just 0.13%.
If that doesn't sound like a big difference, consider that if you invested $100,000 over 20 years and averaged 4% returns, paying a 0.5% annual fee versus a 0.25% fee would reduce your portfolio value by $10,000. If you paid a 1% annual fee, you'd have $30,000 less than if you'd paid a 0.25% fee.
3. Mutual funds require higher upfront investment
Mutual funds usually require an upfront investment that can range anywhere from $500 to $5,000.
But you can invest in an ETF for the price of a single share. For comparison, the SPDR S&P 500 ETF Trust (NYSEMKT:SPY) -- the most popular ETF in the U.S. both in terms of trading volume and assets under management -- closed at $333.88 on Friday, Oct. 3, and many ETF shares cost $100 or less.
4. ETFs win on liquidity and transparency
ETFs have greater liquidity than mutual funds. That's because they're bought and sold like regular securities via a market exchange throughout the trading day. You can only buy mutual funds at the end of the trading day after their net asset value is calculated.
ETFs are also more transparent because most have to disclose their holdings every trading day, whereas mutual funds only need to do so monthly or quarterly.
5. ETFs are often more tax-efficient
You only pay capital gains taxes on an ETF when you sell it. But active managers buy and sell securities to rebalance funds, and if they sell, they can trigger capital gains for mutual funds shareholders.
While ETFs have a slight edge over mutual funds for tax efficiency, this won't be an issue for you if you hold funds in a tax-advantaged retirement account, like a 401(k) or IRA, as many investors do.
When do mutual funds make sense?
One advantage of mutual funds is that you can invest a specific dollar amount because you can buy fractional shares. With ETFs, you often have to buy a certain number of shares, though some brokers allow fractional investing. Because you can invest a specific amount of money, mutual funds are a good option if you practice dollar-cost averaging.
Mutual funds also may have an advantage when you're investing in a specific sector or industry and need the expertise of a human manager.
But when you're investing across a major stock index, ETFs have several key advantages. Regardless of whether you choose ETFs versus mutual funds, focus on keeping fees low and finding funds that you want to own for the long haul.