Mutual fund vs ETF comparison – get the best for your money

You want to invest your money wisely, therefore you have to decide in which asset you go. I give you here a short comparison between mutual funds and ETFs (Exchange traded funds).

In this article I will mainly refer to the return of capital, because this is the most interesting value in investing besides risk.

Mutual Funds

Most of you may have heard about mutual funds. They contain a basket of shares and/or bonds. In general, they have a specific aim, for example to depict the S&P 500 or the emerging markets or a special sector like healthcare. They buy and sell the shares by the order of a management, which has to follow some rules for example, they have to have always a fraction of bonds in their portfolio. These rules differ widely from mutual fund to mutual fund.

One main task of the management is to outperform the market, they are responsible for.
Let´s make an example.
For instance the mutual fund trades the healthcare sector in the United States. Let´s assume that these sector goes up 10%. The management tries to increase the value of the mutual fund of more than 10%. This is simple to understand. But now let’s assume that the healthcare sector suffers a loss of 10% and the mutual fund suffers a loss of 9%. As an investor, you would say, that this is bad, but the management will tell you, that they did very well because the outperformed the market, i.e. they lost less than the market.

Unfortunately most of the mutual fund are not able to outperform the market, instead they underperform the market, i.e. in good times they gain less and in bad times they lose more than the market. Therefore you can think, well, in this case I want to buy the market direct, but how?

Exchange Traded Fund

At this point comes the exchange traded fund (ETF).
The ETF reproduces the market. The market is defined by a fixed fraction of shares and/or bonds. The ETF buys and sells continuously these shares and/or bonds as the market does. There is no manager how manipulates this fraction or tries to outperform the market.

To learn some more characteristics of ETFs take a look at my article: “Day trading strategies

Let’s compare Mutual fund vs ETF

Cost

Now we can make a comparison between the cost of the mutual fund and an ETF.
As you can image from the aim and task of the mutual funds, this investment will be more expensive in general. Expecial the cost of a mutual fund and an ETF can differ extremely, therefore you have to check your investment in detail. This will give you only a general advice.

Mutual Funds

Most mutual funds have a front end load which can differ from 0% up to 6%. This means that you buy a mutual fund for $1,000 USDollar but your account is only 1,000 minus let’s say 5% which equals $950 USDollar.

Some mutual funds charge a back end load. This is an incentive, that you hold the investment over a longer time period. It works like this: You buy the mutual fund today and they have a back end load of 5% over 5 years. If you sell the mutual fund in the first year, you have to pay 5%, in the second year 4% and so on. After six years you can sell it without the back end load.

Furtheron they charge an expense ratio. This is for the hiring of the manager(s), administration cost and ongoing fee for transaction cost and advertising. This expenditure is between 0,5% up to 2%.

ETF

ETF have usually only an expense ratio, which is between 0,2% and 0,6%

Cost Comparision

Comparision_Mutual_fund_ETF

Performance

If you think that this are only one time cost and that they will not affect the performance, than you are wrong!
Especially the starting amount is crucial in determining the performance of an investment. In the following sheet I compare the two investments in a mutual fund with an average cost. I assume a front end load of 5%,
no back end load (0%) and an expense ratio of 1.0%

For the ETF I assume an expense ratio of 0.5%.

The calculation looks like this:Comparision_Mutual_fund_ETF_10_year

As you can see I assume an annual performance of 4%. The second and third column compares the ETF and the mutual fund. The result is that the compounded return is 14% less after 10 years. This is a lot of money.

The last row shows you the “outperformance” which the management has to achieve, to be as good as the ETF. You may say, that is only 1.09% but it is not. The mutual fund has to beat the market by over 13% each year (5.09% / 4 % * 100 = 127.3 %). This would be a very good accomplishment for the management, but remember, only 20% of the mutual funds beat the market and now they have to beat the market consistently by more than 27%. This is a very strong challenge.

Now take this a step further. An average investor build up his saving over 30 years, maybe even longer and you start with your investment with $100,000 US Dollar. The result looks like this:Comparision_Mutual_fund_ETF_30_year

 

The difference sums up to over $50,000 US Dollar or more than 51% compounded return. Can you afford it to loose such a big amount of money?

Conclusion

If you want to invest you have to calculate the cost of every investment very carefully, because in the long run these cost can sum up to a very large amount. The result is clear in favor for the ETF in this rough comparison, but you have to check every investment thorough and determine your personal goals.

I hope that you got a better understanding of mutual funds and ETFs. For further information about ETFs look at my article “Day trading strategies“.
If you have any questions or comments, don’t hesitate to leave a comment below. I will be glad to answer you.

10 thoughts on “Mutual fund vs ETF comparison – get the best for your money

  • 29. March 2016 at 19:24
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    Hey Bernd

    Thanks for this great comparison between ETF and Mutual Funds. I have been wondering about investing for some time now, but still can’t quite wrap my head around it.

    I guess it’s still all a bit over whelming for me at the moment.

    Have you got any advice for me or something to walk me through investing step by step?

    Looking forward to your response.

    Marc Parsons

    Reply
    • 31. March 2016 at 11:22
      Permalink

      Hey Marc,
      thank you for your honest comment. Yes, it may be a little overwhelming, when it comes to investment. But it is not complicated. The only thing is, that you have to think about your personal goals and what you want to achieve in a definite time. When you have the numbers, then take the next step and look what gain you need every year and what risk you want to take. There is always a trade off between risk and return.
      To get more familiar with investing, I recommend, that you take a look at my articles about investment. These will give you a good idea.
      I hope, that this will help and don’t hesitate to ask me again.
      Thanks a lot for your question.
      Bernd

      Reply
  • 30. March 2016 at 19:30
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    I’ve invested in mutual funds as I thought it was a relatively safe bet and was thinking of investing in ETFs as well but never did anything about it. Your article convinced me that I should in fact invest in ETFs since the returns compared with mutual funds are much better especially over a longer term. Thanks for making things simple for me to understand and teaching me that I could actually be saving more money.

    Reply
    • 31. March 2016 at 11:29
      Permalink

      Hello Andy,
      I’m happy, that I could convince you to take action and start to invest. Yes, in general 80% of the etf are better than a mutual fund. So, if you want to invest, this should be your first choice. Thank you for your comment.
      Bernd

      Reply
  • 7. April 2016 at 21:00
    Permalink

    So, for investment purposes, do you only recommend ETF? or sometimes a mutual fund may be a better choice?

    Reply
    • 8. April 2016 at 10:07
      Permalink

      Hello Paulo,
      this is a very good question. This article refers on a comparison between mutual fund and ETF are therefore looks at the advantages and disadvantage of this kind of investment. Of course there are other and, depending on the personal preferences, better investments. This can be for example trading, sharing a company or founding a company, real estate and so on.
      Thank again for your question.

      Reply
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  • 21. April 2016 at 16:57
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    Hi Bernd,

    Appreciate your post here for explaining from the basics and comparing ETFs and mutual funds. It’s certainly very informative article for me.

    Years back, my husband and I used to buy stocks (Singapore). We made good money at first but lost quite a bit later when market was down (round 2008 I think). Since then, we dared not put money in stocks or any investment instruments you explained above.

    But analysing our losses, I believe the bottomline was insufficient knowledge and just ‘going with the herd’ – HUGE mistake. We didn’t have a system that we followed – just going with intuition.

    I believe websites like yours can benefit me and others who might have intentions to invest in such instruments but lack the knowledge. Thank you for taking the time to write this.

    Reply
    • 22. April 2016 at 10:39
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      Hello Zailinah,
      you mention a very common problem, that every new investor has and even “old” or experienced investors struggle with. It is the problem, when to exit an investment. Maybe, you remember the story with Jérôme Kerviel, who loses an unbelievable amount of money and even the BNP got a lot trouble.
      The other point is the system. You need to have a system, a plan, when to enter what and when to exit. If you don´t have this plan, it is like driving in New York without navigation.
      Thanks a lot for your comment, which shows me again the need of people, who want to invest, or already invested and made an unpleasant experience.
      Thanks.
      Bernd

      Reply

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