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ETFs vs. Mutual Funds: Which is Better?

Rob Russell

In one corner with over $9 trillion in assets is the experienced, long-standing heavyweight champion of the investment world: Mutual funds. In the other, with over $1 trillion in assets, is the young and nimble, undefeated rival: Exchange-traded funds, or ETFs. Both competitors are vying for your hard-earned life savings. Which is better for you? You be the judge over the next five rounds:

Round One: Fees

Mutual Funds: According to Investopedia the average stock fund charges an advertised fee of 1.3-1.5 percent, of course specialty or international funds may be costlier. Many brokers, bankers, and advisers charge an additional management fee of around 1-1.5 percent, so you can very easily be paying 2.5 percent or more for a mutual fund portfolio, not counting the tax cost of ownership.

ETFs: In comparison, many exchange-traded funds are less costly than mutual funds, are free from sales commission loads, and, according to the Wall Street Journal, boast an average expense ratio of 0.44 percent, which all things being equal, should keep more money in your pocket. Even with an adviser's management fee of 1 percent, your investment cost is still lower than owning an average mutual fund outright.

Round Two: Transparency

Mutual Funds: Many mutual fund aficionados suffer from a hidden danger in their portfolio: overlap. Because of the utter lack of transparency in the mutual fund industry, it's not uncommon to be holding several apparently different mutual funds that actually hold some of the same stocks, causing you to be overexposed to single companies.

ETFs: Because of their simplicity, ETFs are far more transparent because, in essence, you own different market indexes. If you own a commodity-linked ETF versus large-cap ETF, you don't have overlap (overexposure) because of the specificity of the ETF vehicle.

Round Three: Alternative & Specific Markets

Mutual Funds: In recent years the offerings of mutual funds have expanded into different and alternative markets such as China, gold, long/short strategies, and others so they've become more robust, and consequently more expensive.

ETFs: It's hard to match the access to narrow and specific markets that ETFs offer. Say you want to invest in consumer-product companies in Brazil, or bet that market volatility will increase; there's ETFs for that. One growing area of danger is leveraged ETFs, where you can gain multiplied leverage (double or triple the movement of an index). This can be dangerous for investors that don't have tight risk management because your trade can quickly go against you causing a K.O. punch to your returns

Round Four: Access

Mutual Funds: Most mutual funds have a threshold minimum investment, meaning you must start with $10,000 or so to invest. While this isn't a big hurdle to many investors, it does reduce how far you can spread your risk among many different options.

ETFs: ETFs do not require an investment minimum, so they are accessible to all as long as you have enough to buy at least one share. More importantly this allows smart investors (and money managers) to nimbly spread risk among many sectors, countries, and asset classes, greatly improving the benefits of diversification.

Round Five: Tax Efficiency

Mutual Funds: If there's one thing you give up with a mutual fund portfolio its control, especially control over when you take gains or losses. Mutual funds are one of the most tax-inefficient investments known to man. For example, in a year where a fund loses money investors may still receive 1099s saying they owed tax on gains to add insult to injury. Why? The fund manager may have decided to sell some of the winners (in a losing year) to stop hemorrhaging money from the fund. This can also allow them to advertise a better return for the year. They aren't doing what was in the best interest of the investor; they're doing what's in the best interest of their marketing department.

ETFs: Because ETFs generally follow an index they are far more tax-efficient. You (or your money manager) are in the driver's seat on when it's best for you to take gains or harvest losses. Last, but not least, ETFs trade like stocks (unlike funds that calculate their value at the end of day), so you know exactly the price at which your sell order was executed, giving you certainty on gains or losses.

Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.

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