Should you get a mutual fund or an ETF? An index fund or an actively managed one? Wendy’s or Taco Bell?
After hours upon hours of research, I finally came to a conclusion. To the first two questions, the answer is: it depends.
To the third: I don’t know, man. Why would you even ask that? That’s not what we were looking at here.
I know that’s not the answers you were looking for, but in this article we’ll go over the costs and the performances of ETFs and mutual funds so you’ll be able to make an informed decision.
The Costs of Mutual Funds and ETFs
Cost is one of the most important things to look at when investing in ETFs or mutual funds. If not kept in check, the fees will eat away at your investments, significantly decreasing your profits in the long run.
Both ETFs and mutual funds have what is called an expense ratio. It’s the annual fee you pay to have your money invested in the fund. The expense ratios vary and are usually lower in passive funds and higher in actively managed funds.
For example, if you have $100,000 invested in a fund with an expense ratio of 0.85%, it will cost you $850 a year.
ETFs are also usually burdened by transaction fees. A transaction fee is what you pay your broker to make a transaction. It usually costs between a few dollars to $20, depending on your broker, but some of them have zero commission.
The expense ratios in the infographic are the asset-weighted averages. That basically means that the bigger the fund is, the more its expense ratio affected the average.
A simple average would compare the different funds’ expense ratios without considering their sizes.
The numbers below are just the averages. There are many funds out there that are cheaper and many that are more expensive.
|Mutual Funds||Exchange-Traded Funds|
|Index (Weighted Average)||0.07%||0.18%|
|Index (Simple Average)||0.64%||0.49%|
|Active (Weighted Average)||0.74%||0.77%|
|Active (Simple Average)||1.24%||0.66%|
Index ETFs vs. Index Mutual Funds
A common mistake I see is thinking ETFs are all passive index funds and mutual funds are all actively managed funds. That’s not true. Here you can read up on what an ETF is and how they differ from mutual funds.
So index mutual funds are on average cheaper than index ETFs. And that’s without accounting for potential transaction fees for the ETF.
The good thing about ETFs though is the ease with which you can buy and sell whenever you want to. It’s up to you to decide if that’s something you’re willing to pay extra for.
0.11% looks like a tiny difference between the two, but in the long run, we might be talking about thousands of dollars.
$100,000 invested in a fund with an expense ratio of 0.18% and a 10% annual return will cost you $83,000 in fees in 30 years.
With an expense ratio of 0.07%, it would cost you $33,000. A $50,000 difference.
Basically, if you’re the type of investor who likes to be able to dip in and out of the market, index ETFs might be for you.
If you’re a more passive investor and not interested in trying to time the market, index mutual funds are probably for you.
Actively Managed Funds
A lot can be said about actively managed funds. Like whether or not the comparatively high fees are worth it or not.
In a rational world, a fund with high fees would fetch high returns or protect your investment, but many times that’s just not the case. We will look at the performance of the twenty largest active mutual funds further down.
But when looking at the difference in average cost between active ETFs and mutual funds, there’s basically none.
There’s a spike in the simple average of actively managed mutual funds which means that there are some relatively small but costly active mutual funds out there.
So if you want to invest in an actively managed fund, which one to get isn’t just a question about mutual fund or ETF.
It’s a question about the fund’s management and how likely they are to outperform the market. And if their expense ratio can be justified by the probability of them outperforming.
The performance of active funds
The performance of actively managed mutual funds might come as a surprise to some of you.
Oftentimes when talking about active mutual funds and their often subpar returns, the argument from the mutual funds’ managers and proponents usually goes something like this:
“The main objective of an actively managed fund isn’t to grow your capital at a higher than average rate. The goal is to protect your investment during downfalls in the market.”
So we will also look at how they did in the most recent market crash and how they match up to the S&P500.
At first, I was going to compare the actively managed mutual funds to the actively managed ETFs. But when I was done with the twenty largest mutual funds, I started looking at the ETFs and the difference in size was just way too big to make a fair comparison.
The largest mutual funds were 10 to 30 times the size of the biggest ETF, and more than 100 times most of the other largest ones.
And since the more money you have to manage, the inherently harder it is to outperform the market, it just wouldn’t make for a useful comparison.
Below is the table I put together, showing you the annualized returns of the last five years, as well as the cost of the twenty largest actively managed mutual funds.
I also looked at how much they dropped in the Coronavirus crash from February 10 to March 16, 2020, so we can compare it to how much the S&P500 dropped in the same period.
Active Mutual Funds vs. The S&P500
|Mutual Fund||Expense Ratio||5yr return||10yr||Corona Drop|
Four of the funds beat the S&P500 over five years, and only two over the ten year period. That’s without accounting for how much the expense ratio would have eaten up over five and ten years.
Honestly, that is quite pathetic. And there wasn’t much of a difference between how much the mutual funds dropped versus how much the S&P500 dropped in the same period either.
To look closer at how big the difference is let’s pretend we had invested $100,000 in an S&P500 versus $100,000 in a mutual fund.
S&P500. $100,000 with a return of 13.54% would be worth $188,688 after five years. At the ten year rate of 11.83% it $100,000 would be worth $305,902 after ten years.
Mutual funds. $156,563 after five years and $218,101 after ten.
That’s a $32,000 difference in five years and a $87,000 difference in ten. And again that’s without accounting for expense ratios.
When deciding between mutual funds and ETFs, cost should be a major factor. Especially when deciding between index funds, in that case, it should probably be the chief factor determining which one to get.
When looking at actively managed funds, you have to look at historical performance. But even an acceptable historical performance is no guarantee for future returns.
Lastly, I want to point out that we have compared a lot of averages in this article. There are some mutual funds outperforming the S&P500. You just have to call Nostradamus to see which ones will.
There are also plenty of ETFs and mutual funds cheaper than the average cost we looked at. Many are also more expensive. That’s what an average is.