ETFs and Funds: Both Good

Since the financial crisis, many investors lost faith in mutual funds, especially actively managed ones with higher fees, and flocked to low-cost exchange-traded index funds. This isn’t a bad thing, but there is no reason to categorically exclude mutual funds from your portfolio.

While I am a fan of ETFs and use them extensively in clients’ portfolios, I see no reason to choose between them and mutual funds. Why not use both? Most investors have use for both in their portfolios, but their specific allocation should vary.  

Advantages of ETFs

The appeal of ETFs: They are usually passively managed, meaning they have lower costs because they simply mirror an index. As they reflect a diverse basket of stocks or other securities, ETFs are generally less risky than individual stocks.

Mutual funds also offer diversified portfolios, but many have investment minimums and sales loads, which are like entrance or exit fees. Index mutual funds, like Vanguard 500 (VFINX), are a minority in the mutual fund universe. ETFs are overwhelmingly concentrated in indexes. Unlike mutual funds, ETFs trade throughout the business day, just like stocks.

Originally, ETFs were created as a way to trade various stock market indexes. The Standard & Poor’s 500 SPDR (SPY) just turned 20 years old and is generally at or near the top of the list in terms of ETF trading volume. The availability of low-cost ETFs across a variety of equity and fixed income indexes has grown over the years. As a financial advisor, I use them extensively for their style consistency – and for their consistently good performance within their peer groups.

Especially after the financial crisis, the number of available ETFs mushroomed and so has the variety of offerings. Actively managed ETFs are growing and the success of PIMCO’s Total Return (BOND), an ETF flavor of the firm’s popular Total Return (PTTRX) mutual fund, is sure to spur further growth in ETFs.

Why Bother With Mutual Funds?

In looking at mutual funds, you have to divide them into actively managed funds and passive index funds.

Here are a few of the factors to consider when choosing whether to go with a mutual fund or an ETF:

·       The size of your account or portfolio. Even in the low-cost world of index mutual funds, there are some even cheaper versions available for investors who can meet higher minimum investment thresholds.


·       Cost to own. The expense ratio should be the main deciding factor, but transaction costs can come into play, as well. While the availability of no-transaction fee ETFs is growing, the ETF you want to buy may not be on this menu at a given custodian. Likewise, some mutual fund families also might incur a transaction fee.


·       Your investing style. If you are dollar cost averaging into a fund or ETF every month, you should look for options with no transaction costs.

While actively managed mutual funds get a lot of criticism for seldom beating their index benchmarks, there are still plenty of well-managed, reasonably priced funds across equity and fixed-income styles.

A Schwab study a number of years ago touted a “core and explore” approach to investing. This meant that the core of the portfolio should be index funds, and a smaller investment can be allocated to actively managed funds in certain asset classes where good index products are not available.

Given the wide range of assets classes in both the ETF and mutual fund format, this approach in its original form may be passé. However, I still use a number of actively managed funds across both individual and institutional portfolios.

In choosing an active fund, I look for some or all of the following attributes:

·       Long-term outperformance.

·       Superior risk-adjusted performance.

·       Consistency of management.

·       Something that I can’t find in an index product that adds to the overall quality of the portfolio, such as a good eye for incipient trends.

Certainly, there are a lot of mutual funds that don’t belong in your portfolio. Loaded fundsproprietary funds from various brokerage houses and other unnecessarily expensive alternatives put a lot of money into your broker’s pocket. Usually, the high expense ratios aren’t justified. Go with funds that don’t have loads and always shop for the most inexpensive share class available.

Why Exclude Either ETFs or Mutual Funds?

My point here is not to argue the merits of either mutual funds or ETFs, or for that matter active management versus passive. You can build a great portfolio with one type exclusively or both. It really comes down to your individual needs and goals.

Why limit yourself and feel that you need to avoid either funds or ETFs? So many choices of products can enhance your portfolio and help you achieve your investment goals.

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Roger Wohlner, CFP, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, IL where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter and LinkedIn. Check out Roger’s popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans. He is also a regular contributor to the US News Smarter Investor Blog and has been quoted extensively in the financial press including The Wall Street Journal, Forbes, and Smart Money, Roger is a member of NAPFA, the largest professional organization for fee-only financial advisors in the country. All NAPFA Registered Advisors sign a fiduciary oath promising to act in the best interests of their clients.

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