Making the Switch from Mutual Funds to ETFs

March 1st at 2:00pm by Tom Lydon

ETF mutual fundsFor all the benefits exchange traded funds (ETFs) offer, it’s little shock that they’re trouncing mutual funds in nearly every regard. If you’re an investor hanging onto a mutual fund that just isn’t cutting it, take the opportunity to find a similar ETF that might be a better fit.

The main advantage ETFs have is their low costs, which translate into greater returns for you, writes Jeffrey R. Kosnett for Chicago Tribune. ETFs now include every imaginable investment category, such as broad market funds, specific sector and area funds, and niche, strategy-styled funds. [ETFs vs. Mutual Funds: No Contest?]

  • Minimum investment. Mutual funds often come with a minimum purchase of $2,500 while ETFs can be bought like stock shares, but you still have to pay a brokerage commission per ETF transaction.
  • Holdings. ETFs hold a basket of securities that attempts to reflect performance of an index or benchmark. In this, ETFs are similar to index mutual funds.
  • Price. An ETF’s share price changes like a regular stock price. A mutual fund’s price, or net asset value (NAV), is set after the market closes.
  • Cost. ETF investors don’t need to pay for a large staff of managers and analysts. As a result, the expense ratio of the average ETF is around 0.20% – for every $1,000 investment, one pays $2 in expenses annually. On the other hand, actively managed stock mutual funds charge more than 0.75% and, at times, over 1%.
  • Taxes. ETFs have lower portfolio turnover than regular mutual funds and distribute fewer capital gains. Investors should still consult their tax expert on the benefits of investing in ETFs.

Still, ETFs are not without their flaws. The main problem is when an ETF fails to track its underlying benchmark. For instance, commodity ETFs that don’t own the physical commodities try to reflect the commodity’s market price by trading options and future. [ETF Tracking Error: How It Happens.]

When a mutual fund gets press, the fund brings in more investor cash and the excess assets under management create “bloated” funds that are less able to be easily shifted around, comments Gary Gordon for ETF Expert. In trying to find out how buying-and-holding comparable ETFs fared against what Rob Silverblatt of U.S. News calls “The Best Mutual Funds For 2010,” Gordon decided to look at three ETF categories.

  • Emerging markets. Comparing Eaton Vance Tax-Managed Emerging Markets (EITEX) and Vanguard Emerging Markets Stock (NYSEArca: VWO), Gordon found the mutual fund EITEX provided a 17% total return excess value over five years. Investors should know that around 86% of all mutual funds haven’t been able to beat a comparable index over the long-term since the mutual funds tend to perform close to the mean in extended periods. [More on Emerging Markets.]
  • Health. Silverblatt nominated Fidelity Select Medical Equipment and Systems (FSMEX) as its health fund, but the fund does not represent the broader health care sector. iShares Dow Jones U.S. Medical Devices (NYSEArca: IHI) may be a reasonable comparison to the mutual fund. Both launched around mid-2006 and IHI has outperformed. Additionally, the high volatility between then and now would have allowed an ETF investor to use trailing stop-loss orders to navigate the highs and lows of the market. [More on Health Care.]
  • Large growth. The nominated Parnassus Workplace (PARWX) fund is less volatile than the PowerShares QQQ (NASDAQ: QQQQ), but the performance of PARWX is only on par with QQQQ. [More on the NASDAQ.]

Bottom line? If making the switch from a mutual fund to a correlating ETF makes sense for you, by all means do it. You could find yourself saving money on fees, having more trading flexibility and reaping the rewards of more reliable performance as your ETF tracks the market instead of fruitlessly trying to beat it.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.