ETF or Fund Better? Depends Who You Ask...

May 20, 2008

An audience member at some sort of live CNBC event asks a seemingly simple question about exchange traded funds:

"For the small investor that wants to hold their investment for awhile and they are looking at a mutual fund verses an ETF and it's the same sector and it's the same kind of portfolio, why would you buy a mutual fund over an ETF given that the ETF usually has lower costs?"

...and in response gets day-trader mumbo jumbo from the expert panelists. The conclusion seems to be that ETFs are essentially always better because investors can buy and sell them intraday (so much for the 'small investor that wants to hold their investment for awhile' part), because the market gains big on some days and you don't want to miss those days.

Of course the market also falls big some days and investors would want to miss those days - and could benefit from ordinary open end funds which only execute investors' buy trades at the end of the day. For a longer-term investor, intra day price swings are irrelevant because those investors have no idea if the market is going down or up the day they buy in.

What is relevant is that ETFs can be cheaper to own, but can also be more expensive than similar open-end funds if not managed correctly.

For those who are going to add money to their holdings along they way, no-load funds that are bought directly from the fund family can save money on commissions if the fund fees are not far more expensive than an ETF. Most Vanguard and Fidelity index funds are as cheap as ETFs (and in many cases cheaper) and offer a cost advantage when considering the commission and bid/ask spread to buy and sell ETFs.

The trouble of course is figuring out which actively managed fund will beat a benchmark index going forward - a task bordering on impossible. On the other hand, what are your chances of beating a benchmark index buying and selling ETFs like a mad hatter?

We prefer a mix of lower fee actively manged open-end funds and index funds to an all-ETF portfolio. Depending on how you are using them, the index funds can be open-end or ETFs. We also think more harm than good will ultimately be caused by most of the new fangled ETFs being launched nowadays.