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.
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
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.
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 have usually only an expense ratio, which is between 0,2% and 0,6%
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:
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:
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?
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.