All investors are eventually faced with the question of whether to be an active or passive investor. For the latter, mutual funds used to be the de facto option. However, the rise of exchange traded funds (ETFs) has put that dominance into question.
According to Matt Hougan of Index Universe, “ETFs aren’t just equivalent to mutual funds, they’re qualitatively better.”
The first advantage that most likely comes to mind is that ETFs are cheaper to own. But Hougan explains that there are mutual funds with lower expense ratios than ETFs. He also notes that ETF investors bear the weight of commissions and bid/ask spreads, which mutual fund investors don’t have to pay. [Commodity Investing: ETFs vs. Mutual Funds.]
Instead, Hougan explains that the real advantage to owning an ETF is that it is fairer to the individual investor than a mutual fund. When clients redeem their positions in a mutual fund, continuing clients must bear the weight of trading costs and any capital gains incurred on those trades. Likewise, when new money is brought in, the existing clients must pay for the costs of putting that money to work. [The All-ETF 401(k).]
On the other hand, an ETF shields individual investors from the decisions of others. “No paying for other people’s commissions, no paying for other people’s market impact, and, by and large, no capital-gains distributions driven by the actions of others.”
ETFs aren’t a fail-safe alternative, since investors are still exposed to the risk of paying too much for an ETF. But, with the correct strategy, long-term investors can benefit from the fairness of ETFs compared to mutual funds. [How to Follow the Trends]
For more stories on ETF basics, visit our ETF 101 category.
Sumin Kim contributed to this article.