Although some people prefer one or the other, I believe that you have to look at them as two both complementary and, yet, competing investment tools. Actively-managed mutual funds have been around since the 1930s. ETFs (or Exchange-Traded Funds) , however, came into existence when the first, SPY ETF (which replicates the S & P 500), started operation in 1995. But, what’s the difference?
Mutual funds have become quite popular, initially due to the ability of the small investor to have a somewhat diversified portfolio when investing only a few thousand dollars, and sometimes even less. Additionally, you get a team of experienced professionals who can manage the portfolio for the investors.
Mutual funds are available that invest in stocks, bonds or a combination of them, as well as other securities. The are funds that invest in a wide range of stocks or bonds (large and small, high quality or low, different investment styles and foreign and domestic. Some invest in only one country or region (i.e. Brazil or Scandinavia), or certain industrial sectors or commodities (Technology or Natural Resources). There is virtually a mutual fund for every taste and comfort level.
ETFs are a fast-growing type of mutual fund, which have grown in popularity. They are also in both broad-based, or narrowly-focus varieties–stocks and bonds, foreign and domestic, one-country or region, and industrial sector and commodity offerings. ETFs are mostly based on a particular market index, such as the S & P 500 or the EAFE (Europe, Australia and Far East); however, we are now seeing the entrance of a few actively-managed ETFs into the marketplace. Some investors merely use ETFs to fill-in the portfolio gaps that mutual funds don’t provide.
A key difference is that the pricing of mutual funds versus ETFs. Whether you are buying or selling, mutual fund prices are usually determined at the close of business (generally 4:00 PM ET) daily. The price of ETFs, however, changes on a moment-by-moment basis (just like individual stocks). They trade mostly on the NYSE or NASDAQ.
Some people use mutual funds because the Investment Manager will generally choose which securities to buy or sell. Since ETFs are mostly index funds, they pretty much have to take the good with the bad–across the particular index; however, more recently, managed ETFs have become available.
Some institutional investors like the fact that, with an ETF, whether buying or selling, you can lock the price at that minute–without waiting for the 4:00 PM market close. However, for the long-term investor, a small price differential might not mean much with a ten or twenty year time horizon. So, the ability to be more selective might prove beneficial in the long run. Now, for some examples.
In late November of 2008 (a time when there was extremely wide swings in the market), when (then) President-Elect Barack Obama named his Economic Team, the market acted with a substantial upward surge. Basically, knowing the Cast of Characters who would be steering the Economy helped reduce the prevailing uncertainty–at an extremely stressful time in the Financial Markets. So, institutional investors, which usually invest in individual stocks, were making very large investments primarily in ETFs which replicate the major indices (Dow Jones Industrials, S & P 500, NASDAQ and a few others)–just to get money INTO the market on short notice.
However, when the excitement wore off and people continued to see how high unemployment still was , those same ETFs were the easiest way to get money OUT of the market. By buying or selling just one security, an investors can, in effect, move considerable amounts of money–either into or out of a broad-based portion of the securities markets.
Now, most people believe that “The Stock Market” reached bottom on March 9 of 2009, and roughly doubled in the three years afterward. And, that was the magic date for just about every major index of Developed Market Economies. But, most of the Developing Markets (i.e. Brazil, Russia, India, China, South Africa, Poland, etc), bottomed on March 2nd of that year. Thus, the Developing Markets, at least to me, led The Great Recovery.
Later in 2009, I compared some statistics of quarterly performance for several major Emerging Market ETFs and comparable Mutual Funds (i.e. China, Brazil, Diversified Emerging Market–as a group, etc.). I found that, in the early stages when money was gushing into Emerging Markets, ETFs were leading mutual funds by a wide margin. By early Fall, however, when the market began to cruise at a steadier pace, management selectivity took over the lead
Again, institutional investors like ETFs, due to their easy Entrance to, or Exit from, the market. So using the two types of securities in combination may very well be a good complementary approach–just know when to shift gears–one to the other. Also, for some countries (i.e. Turkey, Chile, Australia), ETFs might be he only security available when there is not a mutual fund that focuses on it.
ASK YOUR FINANCIAL ADVISOR TO EXPLAIN THIS CONCEPT TO YOU, WITHIN THE CONTEXT OF YOUR OWN RISK TOLERANCE, GOALS, FINANCIAL STAMINA AND PREFERENCES. THEY CAN ALSO MAKE SPECIFIC RECOMMENDATIONS AND PROVIDE YOU WITH A PROSPECTUS.