Pros and Cons – An ETF vs Mutual Fund

What are the pros of a Mutual Fund? What are the advantages of an ETF? Do either have serious disadvantages?

Mutual Funds are older than ETF’s or Exchange Traded funds. Mutual funds started to first appear in the 1920’s, whereas ETF’s have only existed since the 1990’s. Both of these investment vehicles are bundles of securities (bonds,stocks, etc). The main purpose of each is to provide DIVERSIFICATION. They’ll save you the hassle of buying hundreds of stocks, incurring lots of commissions, and more.

What are the Cons and Pros of a Mutual Fund vs. ETF

Pros of an ETF

  • Low fees
  • Can sometimes get below Net Asset Value (arbitrage)
  • Can buy and sell throughout the day
  • Can purchase leverage or inverse ETF’s
  • An easy way to track an index
  • Low Taxable Distributions/Gains
  • Minimum Investment very low.

One of the biggest advantages of an ETF is the low fees associated with it. You can get a number of ETF’s now with almost no expense ratios through Fidelity and Vanguard. Once again, given all the ‘work’ done by an ETF, a .1-.4% Expense Ratio will seem like nothing. The low fees are because there isn’t an active manager for an ETF, it is largely a passive investment.

One advantage an ETF has over a Mutual Fund is that it can be purchased below NAV. This arbitrage usually shows up during very volatile markets. In normal circumstances, the difference in price and NAV is very little, so not a huge advantage. The price you pay for an ETF is determined by supply and demand. A mutual fund’s price is not determined by supply and demand on the secondary market.

For those with a serious appetite for risk, you can purchase leverage or inverse ETF’s. For example, suppose you believe a market correction is in order; you can short the Nasdaq through something like SQQQ. However, these ETF’s do come with lots of risk, so please research that before you get involved. This is not something I’ve done nor encourage.

ETF’s provide an easy way to track an index like the S&P 500 or Russell 2000. Imagine how much money you’d have to spend to buy every stock in the S&P 500. How much in commissions you’d pay. A total market ETF provides you with an incredible amount of diversification. For those interest in sector rotation, you can even use ETF’s to target certain sectors of the stock market. For example, there are energy or healthcare sector ETF’s.

Another advantage an ETF has over a Mutual Fund is that it tends to distribute less capital gains throughout the year. So, if you want to hold a Total Market or S&P 500 ETF in a taxable account, it’s actually not detrimental.

The minimum investment is very low with an ETF. Some mutual funds require thousands of dollars as an initial investment. Just for an example; in my account, I have ETF’s that cost $40.

Cons of an ETF

  • Passive, while a good thing, can also be a bad thing
  • Auto-reinvestment
  • Partial Shares more difficult

One could argue with a passive ETF, it puts you at greater risk if the market suffers a large correction. The ETF is simply tracking the particular index, it isn’t trying to get you out of anything or be tactical. However, we also know over the long-term and in general, passive funds have done a better job than active funds. There are some active ETF’s, but these are the exception.

Auto-reinvestment is very easy with mutual funds, not so with ETF’s. If you want to re-invest, you’ll have to go in and manually re-invest the dollars back into the investment. So, on your end, this is a less passive approach.

Mutual Funds offer the benefit of partial share investment. For example, let’s say my mutual fund pays a $5 dividend and the NAV is $120. It doesn’t matter, I can take the $5 dividend and purchase a partial share in the mutual fund. With an ETF, this is not easily done. I’ve heard it’s possible but it is not something I’ve encountered myself.

Pros of Mutual Funds

  • Partial Shares
  • Auto Re-investment
  • Diversification

As I just got through discussing, you can buy partial shares easier with a mutual fund.

Auto reinvestment has never been easier. Want a hands off investment approach? There is nothing easier than a mutual fund on auto reinvestment. If your Mutual Fund pays a dividend, you can set it up to where it takes that distribution and it auto re-invests the amount right back into the mutual fund.

Cons of Mutual Funds

  • Doesn’t Trade on secondary market throughout the day
  • Higher Expense Ratios sometimes
  • Capital Gain Realization

Does not trade on the market during the day. If you think you’ll want to trade more actively, a mutual fund isn’t for you. In fact, you might get flagged by Vanguard or Fidelity for excess trading if you are moving in and out of mutual funds often. Mutual funds trade at NAV at the end of the day.

Higher expense ratios can appear with mutual funds.. However, Fidelity now has Zero fee mutual funds like FZROZ,

One of the biggest cons of a mutual fund is you don’t get to determine when capital gains are realized. Most mutual funds I’ve owned distributed long-term and short-term capital gains. In the case a mutual fund is held outside a retirement account, this will result in greater tax liabilities. Especially in the case of the short-term capital gains. Please consult your tax advisor/accountant on this matter!

Closing Thoughts on the Advantages of ETFs and Mutual Funds

I think the choice between the two comes down to each investor and I certainly can’t steer you towards one or the other. However, I do own both in my accounts. I’ve had VTSAX ever since I started investing in my Roth IRA. I also have ITOT and other ETF’s in my other accounts. Check out what is out there and see what might fit your own needs!


Similar Posts