ETFs vs Mutual Funds

Mutual funds are actively managed funds that pool together money from many investors to purchase stocks, bonds, etc.
Mutual funds are typically managed by professional fund managers at large financial institutions. Because mutual funds are actively managed by a person, or team of professionals, they often have much higher fees associated with them.
The first fee associated with mutual funds is what’s called an expense ratio. An expense ratio is the “management expense” associated with holding the fund. It is not uncommon to see most mutual funds maintain expense ratios of 1 to 3%, or even higher.

Dangers of Mutual Funds

Let’s assume you invest $1,000 into a mutual fund with an expense ratio of 2%. This means you will pay the fund $20 per year for every $1,000 invested.
And while 1% may not seem like a lot, what many of us don’t realize is that an increase of 1% in fees will cost you 10 years in retirement income.
In addition, many mutual funds have additional fees called “front-end loads” and “back-end loads.” Loads are fees charged to the investor when buying or selling certain types of mutual funds.
With these types of mutual funds, you either pay a fee up front when purchasing into a mutual fund, or on the back-end when you sell the fund. Typically, these fees can average around 5%, but can be higher depending on the fund.

Mutual Fund Returns

As a benchmark, the performance of mutual funds are often compared to the performance of the S&P 500. Remember, this is the index that tracks the performance of the 500 largest US companies.
And while some mutual funds do outperform the overall stock market over a certain period of time, most actively managed mutual funds do not outperform the market.
But there is a better alternative. Most people don’t realize that you can easily invest in the S&P 500 through a low-fee index fund instead of picking individual socks or paying high fees for mutual funds that, statistically, won’t outperform.
Research has shown that 96% of all actively managed mutual funds fail to beat the market.
The better choice is clear… investing in exchange traded funds (ETFs).

What are ETFs?

An ETF is a group of related stocks bundled together in a single investment. Sound familiar? That is exactly what an index fund is!
Can you imagine how expensive it would be to buy all the stocks held in an ETF portfolio individually? Not to mention, overwhelming.
With access to hundreds of stocks in a single ETF, they provide lower average costs than buying the individual stocks themselves.

Do ETFs Have Fees?

Similar to mutual funds, ETFs charge fees in the form of expense ratios. But unlike mutual funds, ETFs expense ratios are drastically lower.
While most actively managed mutual funds have expense ratios ranging from 1 to 3%, compare that to the expense ratios on these popular S&P 500 ETFs:
  • Vanguard S&P 500 Index ETF (VOO)
    • Expense Ratio: 0.03%
  • Vanguard Total Stock Market ETF (VTI)
    • Expense Ratio: 0.03%
  • Vanguard High Dividend Yield ETF (VYM)
    • Expense Ratio: 0.06%
  • Vanguard Total World Stock ETF (VT)
    • Expense Ratio: 0.08%
That’s right. Warren Buffet’s recommendation, the Vanguard S&P 500 Index ETF (VOO) has an expense ratio 33x less expensive than a mutual fund with only a 1% expense ratio.
To put this in perspective, imagine you had $100,000 invested in a Vanguard S&P 500 Index. Then imagine you had $1,000,000 invested. I mean, that is the goal right?
  • $100,000 x 0.03% (expense ratio) = an annual fee of $30
  • $1,000,000 x 0.03% (expense ratio) = an annual fee of $300
Compare that to a similar actively managed mutual fund with an expense ratio of just 1%:
  • $100,000 x 1% (expense ratio) = an annual fee of $1,000
  • $1,000,000 x 1% (expense ratio) = an annual fee of $10,000
Not only are you saving a critical amount in fees every year, but those savings get to stay invested, allowing more of your money to compound and grow at an even faster rate.
We’ll talk more about the power of compound interest in the next module.
One important point to note, is that not all ETFs track an index in a passive manner. While most do, there are also actively managed ETFs. And similar to actively managed mutual funds, those actively managed ETFs will hold a higher expense ratio.
So when considering ETFs to invest in, you always want to check the expense ratio before investing. That will give you an idea if it is a passively or actively managed ETF.
When you invest in ETFs you get the full experience of being a stock market investor without the increased volatility of owning individual stocks.
So let’s now take a second to discuss the advantages vs the disadvantages of investing in ETFs.

Advantages of ETFs

Investing in ETFs give you the following benefits:
  • Avoid having to actively manage and pick individual stocks
  • Risk management through instant diversification
  • Access to many stocks across various industries
  • Low expense ratios
  • Access to ETFs that focus on targeted industries

Disadvantages of ETFs

  • Actively-managed ETFs have higher fees
  • Single-industry focused ETFs limit diversification
Some of the best platforms to invest in ETFs are M1 Finance, Public, and Robinhood.
Now, in the next video, we’re going to cover investing in individual stocks. Because, investing in individual stocks can have it’s advantages as well. So I’ll see you in the next video!