Mutual Funds or ETFs: How do I choose?

Both mutual funds and exchange-traded funds (ETFs) share some important features that can serve investors well. Each allows diversification by bringing together dozens — sometimes hundreds or even thousands — of individual stocks or bonds (or both) into a single offering.¹

But there are some significant differences between them. "Understanding those differences can be the key to building a portfolio that helps you meet your goals," notes Raj Kohli, head of Portfolio Research and Analysis, Chief Investment Office, Merrill and Bank of America Private Bank. "Mutual funds might make more sense in certain situations, while an ETF might be a better pick in others. The right approach for you might not be either/or. Both could have a place in your portfolio."

One important distinction between mutual funds and ETFs can come from the way they're managed. While mutual funds can be either actively or passively managed, most ETFs are passively managed — though actively managed ones are becoming increasingly available. What do these terms mean?

With an actively managed fund, a professional fund manager chooses which individual securities to buy with the aim of getting the highest possible return. Such a fund can deliver returns that perform appreciably better or worse than the market as a whole.

A passively managed fund aims to mimic the performance of a specific market benchmark or index — such as the S&P 500 — and is made up exclusively of the securities in that index. (That's why they're often referred to as index funds.) A passively managed fund is unlikely to perform significantly better or worse than the benchmark it follows.

For more insights on how they differ, take a look at four common investor scenarios — chances are you'll fit into one or more of them.

Both mutual funds and ETFs allow you to target specific market sectors, such as healthcare or real estate, or specific countries or regions. ETFs tend to offer more specific choices — in a category like healthcare, for instance, you can find ETFs focused on market niches such as medical devices or biotech. On the other hand, an actively managed mutual fund can have its advantages. "Professional managers tend to specialize in certain sectors, and you might benefit from their knowledge," suggests Christopher Vale, senior vice president, Digital Advice and Investment Solutions, Bank of America.

Mutual funds might be worth considering in this case, says Kohli. Many don't assess a sales charge when you buy or sell shares. (In industry jargon, they're called no-load funds.) Some require a minimum investment to open your account but allow for subsequent smaller investments. Others charge no sales fee if you set up automatic direct investments.

By comparison, ETF shares are bought and sold like individual stocks, so any transaction may involve a fee. "As a result, if you make ongoing modest-sized investments — say biweekly or monthly — any fees can add up and eat into potential gains," Vale says.

Some investors enjoy monitoring the market to try to capitalize on short-term trends and shifts. For those who plan to actively trade their shares, ETFs might make sense.

While markets are open, the share price of an ETF rises and falls — much as a stock does — based on the changing value of its underlying securities. That makes it easier for an investor to take advantage of short-term movement in the markets. On the other hand, a mutual fund's share price is generally set once a day, based on the price of its securities at the market's closing bell.

Actively managed mutual funds can make sense, especially "if you're interested in less-discovered opportunities," Vale says. "In heavily traded markets, like the U.S. large-cap stock market, most, if not all, of the information about a company is already known, so it's difficult to find inefficiencies there." In more thinly traded markets — Vale cites high-yield fixed income, small-cap stocks and emerging market stocks as examples — "the specialized knowledge of a professional money manager could add real value." Just bear in mind that by choosing active management, you're in effect hiring a money manager for his or her expertise in that particular market. That expertise will come with higher expenses, which will lower your returns.

How do you go about finding an active manager that suits your needs? First, identify what it is you want to accomplish by investing. For example, do you want to build a fully diversified portfolio?² If so, you'll want to choose funds that will cover each asset class — such as stocks and bonds —in your asset allocation. Once you know what parts of the market you want access to, choosing a manager is a matter of weighing several factors such as expenses, the manager's track record (although you should keep in mind that a manager's track record is no indication of what his or her future record will be), and how long the person has managed the fund.

The bottom line: Both mutual funds and ETFs serve a purpose — whether one is "better" than another is entirely a matter of your circumstances, objectives and investing preferences. A firm grasp of your goals is the essential starting point, Kohli points out, but it's also critical to understand how much risk you're willing to take on as well as your time frame for reaching your goals. "Armed with that information," he says, "you're in a much better position to decide on the approach that may be appropriate for you."