Imagine this: you have your hard-earned savings in hand and are ready to start investing. Rather than actively picking stocks to beat the market, you’re interested in a more hands-off approach. You’ve heard about passive investing—but should you go with the traditional reliability of mutual funds or the rising popularity of exchange-traded funds (ETFs)?
Both promise to grow your wealth, yet each has a slightly different approach to achieving this goal. Understanding the nuances of these investment vehicles isn’t just helpful; it’s essential. So, let’s embark on a journey through the world of ETFs and mutual funds, exploring their strengths, challenges, and potential futures. By the end, you’ll be equipped to make an informed decision tailored to your financial goals.
Why are mutual funds still popular?
According to the Investment Company Institute, as of 2023, U.S. mutual funds held approximately US$25.5 trillion in total net assets, compared to ETF’s US$8.1 trillion. This substantial lead can be attributed to several factors in which the historical presence of mutual funds plays a significant role. Mutual funds have been around in the US since 1924, fostering familiarity and trust among investors over the decades, while the first U.S. ETF was only launched in 1993.
Furthermore, U.S. employer-sponsored retirement plans, especially 401(k)s, have been a stronghold for mutual funds. These plans are often structured to favour mutual funds as a default investment option. As of 2023, 65% of 401(k) assets were invested in mutual funds, underscoring their deep integration into the retirement savings system.
Challenges in the mutual fund space
Despite their popularity and inherent advantages, mutual funds face several challenges. Not all mutual funds achieve the impressive returns of standout performers like Fidelity Blue Chip Growth, which delivered a remarkable 10-year annualized return of 17.5%, surpassing the S&P 500’s 12.7%. Many actively managed funds struggle to consistently outperform their benchmarks. This underperformance is further compounded by high fees associated with active management, which can significantly erode returns over time.
Furthermore, unlike ETFs, mutual funds are priced and traded only once per day, lacking the intraday trading flexibility that some investors seek. Additionally, mutual funds may be less tax-efficient because of their capital gains distributions, which can impact overall returns for investors by triggering taxable events.
The ETF revolution
In contrast, ETFs have gained significant attention for several advantages. They typically come with lower costs, especially for passive index-tracking funds, which can enhance long-term performance. For example, the average expense ratio for actively managed mutual funds stands at 0.66%, compared to just 0.16% for the average index ETF. Additionally, the unique structure of ETFs generally results in fewer capital gains distributions, making them more tax-efficient than mutual funds.
Another appealing aspect of ETFs is their trading flexibility. Like stocks, ETFs can be bought and sold throughout the trading day, giving investors more control over their entry and exit points. Additionally, most ETFs disclose their holdings daily, providing greater transparency compared to mutual funds, which typically report their holdings on a quarterly basis.
| Feature | ETF | Mutual Fund |
| Trading | Intraday | End of day |
| Minimum Investment | Price of one share | Typically ranges from $1,000 – $3,000 |
| Expense Ratios | Lower | Higher |
| Tax Efficiency | Higher | Lower |
| Transparency | Daily holdings disclosure | Quarterly holdings disclosure |
| Type of Fund Management | More passively managed | More actively managed |
Will ETFs eventually overtake mutual funds?
According to Yahoo Finance, active ETFs have been steadily taking market share from mutual funds, with assets growing by 20% annually over the past five years. While ETFs are continuing to gain ground, it remains unlikely that they will completely overtake mutual funds in the near future. The retirement plan system still favors mutual funds, making them the default choice for many investors in 401(k) plans and similar accounts. Additionally, in certain market segments, active management can still provide added value, allowing mutual funds to maintain a niche and continue thriving alongside ETFs.
The mutual fund industry is also evolving to stay competitive. As shown in the chart below, mutual fund expense ratios have been steadily decreasing since 2000 to better compete with the low-cost advantage that ETFs offer. This trend reflects the industry’s efforts to adapt to investors’ increasing demand for lower fees and cost-effective investment options.
Several major asset management companies, including Fidelity and Morgan Stanley Investment Management, are seeking SEC approval to create ETF share classes for their existing mutual funds. This approach allows these firms to offer ETF versions of their mutual funds, potentially combining the strengths of both structures. Investors could trade these funds on an exchange like an ETF, while also enjoying the benefits of low costs and improved tax efficiency.
The fifth perspective
The choice between ETFs and mutual funds is not always straightforward. Investors might lean toward an ETF if they trade more passively, seek niche market exposure, and prioritize tax efficiency. On the other hand, actively managed mutual funds may be more appealing for those aiming to beat the market, particularly if they believe they are investing in a less efficient market. Ultimately, the decision depends on personal investment goals, risk tolerance, and the specific characteristics of each investment type.
