5 Reasons to Choose Mutual Funds Over ETFs

The debate regarding the relative efficacy and profitability of mutual funds versus exchange-traded funds (ETFs) has been a hot topic in the investment community for some time. Like any investment product, mutual funds and ETFs both have their benefits and drawbacks and are better suited to some investors than others.

Though ETFs have become rather fashionable because of their market-based trading and typically lower expense ratios, there are still solid reasons to choose mutual funds over ETFs.

Key Takeaways

  • Mutual funds are more prevalent in the marketplace but are gaining popularity.
  • Some mutual funds are actively managed and have some risk due to leverage but limit the amount that can be used.
  • ETFs are generally less expensive than mutual funds, but this comes with less management and, thus, reduced services.
  • You can set up automatic purchases and withdrawals to and from a mutual fund, but you cannot to an ETF.

Wider Variety

The chief advantage of mutual funds that cannot be found in ETFs is variety. There are more mutual funds available for all different types of investment strategies, risk tolerance levels, and asset types.

In general, ETFs are passively managed indexed funds that invest the same securities as a chosen index in the hopes of mirroring its returns. While this is a perfectly viable investment strategy, it is pretty limiting. Mutual funds offer the same type of indexed investing options as ETFs, and they provide an impressive array of actively and passively managed options that can be fine-tuned to cater to your needs.

Investing in mutual funds allows you to choose a product that fits your specific investment goals and risk tolerance level. Whether you want a more stable investment that generates modest returns, an investment that provides regular income each year, or a more aggressive product that seeks to beat the market, there is a mutual fund for you.

Active Management Without Leverage Risk

Of course, there are some more actively managed ETFs and a newer breed of product that provides a higher-risk/higher-reward option. By using borrowed money to increase the size of the fund's investment, leveraged ETFs seek to generate some multiple of an index's returns. While these securities still track a given index, using debt to bet big without the shareholder equity to back up the gamble makes leveraged and inverse ETFs completely different species of investments.

Leveraged and inverse ETFs are the topic of much discussion because of their fickleness. Though they can be very lucrative options if the market performs as predicted, the combination of leveraged returns and day-to-day market volatility can make them dangerous investments over the long term.

Clearly, the ETF options available tend to be fairly black and white—either extremely passive indexed funds that provide moderate returns with little chance of big gains or aggressively managed high-yield funds or risky leveraged products. If you want a certain degree of stability with just a dash of risk, there is little room. Conversely, mutual funds come in all possible combinations of security and risk.

For example, If you want an investment that focuses on long-term capital gains, you can find a mutual fund that primarily invests in proven growth stocks but also looks to benefit from early identification of up-and-coming businesses poised for exponential growth. The tried-and-tested stocks form a solid basis for long-term gains, while investments in newer or undervalued stocks provide the potential for rapid growth in exchange for a certain degree of risk. Unlike ETFs, mutual funds don't have to be all-or-nothing investments.

In addition, mutual funds are strictly limited regarding the amount of leverage they can use. Mutual funds can borrow capital, but they must ensure that they have "an asset coverage of at least 300 per centum"—or only one-third of the total value of a fund.

Service Quality

ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be slightly more costly, fund managers provide support services. In addition to phone support from knowledgeable personnel, mutual funds may offer free funds transfers, check-writing options, and other shareholder services that ETFs don't provide.

Automatic Investment Options

Some of the most useful services offered by mutual funds that cannot be found when investing in ETFs are automatic investment plans. These services facilitate regular contributions without lifting a finger, helping you grow your investment effortlessly.

By utilizing these options, you can automatically increase your mutual fund investment by a predetermined amount each month. This provides an easy way to grow your nest egg without making the monthly decision to allocate those funds to your portfolio or use them for other things. Given a few hundred dollars of discretionary income each month and the choice of how to use it, many people might elect to spend it on non-essential activities or purchases rather than making the wise choice of investing it. An automatic investment plan makes that choice for you.

Like an automatic investment plan, dividend reinvestment plans (DRIPs) take the stress of decision-making out of the equation by automatically converting dividend distributions into investment growth.

No Commission Fees

Another reason mutual funds can be the better option is if your investment plan includes incremental investment over time. While ETFs are often touted as the cheaper option because of their relatively low expense ratios, shareholders still have to pay broker commissions each time they buy or sell shares. If you plan to make one large investment, ETFs may be the cheaper option if one of the products available can meet your investment goals.

Many people, however, prefer to grow their investments over time. This allows you to see how a product performs before committing fully, and it can be a much more sustainable investment strategy. Not everyone has $10,000 or more to invest all at once. In addition, the practice of investing a set amount each month—called dollar-cost averaging—means you will end up paying less per share over time; you will purchase more shares with the same amount of money in months when the share price is low.

Though mutual funds sometimes carry up-front fees for first-time investors, they make it cheap and easy to increase your investment down the road. In addition, the availability of automatic investment and DRIP options makes incremental mutual fund investment virtually effortless. To build your ETF investment similarly, you would incur commission or transaction fees each month, which can substantially reduce your take-home profit.

Why Are Mutual Funds Safer Than ETFs?

Neither type of fund is inherently safer than the other—safety depends on their capital structure and what they are designed to do.

What Are the Advantages of Mutual Funds Over ETFs?

Mutual funds generally provide support services, while ETFs do not. Mutual funds allow automatic withdrawals and investments, while ETFs do not.

Is an ETF Riskier Than a Mutual Fund?

Both funds inherit the risks of the assets included in them, as well as management risk and others. Neither is riskier than the other unless they are designed with more risk and the possibility of higher returns in mind.

The Bottom Line

Though both mutual funds and ETFs can be smart investment choices, there are some clear reasons why mutual funds may be the better choice, depending on your investment goals and strategy. However, there's no reason you cannot further diversify your portfolio by investing in both asset types if they serve your long-term goals in different ways.

Article Sources
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  1. GovInfo.gov. "Investment Company Act of 1940," Pages 57-59.

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