#Mutual #funds are a wildly popular option in the U.S. - especially in workplace retirement plans such as 401(k)s - with total assets under management of ~$19 trillion. These funds are typically bought and sold through investment companies instead of on public stock exchanges and therefore, unlike publicly traded ETFs, they do not always have trading commissions (though some do!). However, they almost always do charge an annual management fee, commonly referred to as an expense ratio, as well as other transaction-related and account maintenance fees.
Mutual funds usually come in two classes: passive and actively managed. Passive mutual funds are often linked to an index (such as the Dow Jones Industrial Average, Nasdaq, or S&P 500) which in turn means that they are much more efficient due to lower trading and taxation costs. As such, they often have very low expense ratios and minimal to no transaction fees.
These funds are often a great choice for passive investors if they invest a fairly consistent amount on a frequent schedule such as monthly or quarterly. This technique, known as dollar cost averaging, minimizes timing risk by eliminating the possibility of investing all of one’s money right before a market crash occurs. Since these funds have little-to-no transaction fees and very low expense ratios, they are ideal solutions for regular savers and investors since these low costs match up well with the fact that the stock market indices are known to appreciate at a pretty steady clip over the long term.
However, while index mutual funds certainly have their pros, they do have some negative trade-offs. First, you are guaranteed to always slightly underperform the market by receiving a market-level return before fees are subtracted. Second, you have no control over holdings. You own shares in companies regardless if you approve of the products or services they provide or if you think they are worth investing in or not. Finally, you have no downside protection. If the stock market sells off, your investment will do so right along with it. There are no hedges offered within the fund against sharp declines. While you can always invest some of your savings in another fund, such as a bond fund, to hedge your overall portfolio against declines, this requires additional account maintenance and can also increase your fees thereby offsetting some of the main arguments in favor of holding index mutual funds.
The other type of mutual fund is the actively managed mutual fund. These vehicles involve a portfolio manager selecting individual stocks and bonds of varying weights according to the fund’s strategy and the manager’s conviction whose opinions are typically supported by a team of research analysts. The pros of this structure include the potential to outperform the market, being able to invest your funds in a manner that more closely aligns with your preferences (whether strategic or moral), as well as potentially more protection against downside risk.
Of course, however, these pros come with some cons. These include higher fees due to the significantly higher transaction, management, and research costs, the potential to underperform their index (especially net of fees), less tax efficiency (due to greater portfolio turnover).
The other fund structure is the ETF. While they have been around for a little over two decades, over the past decade #ETFs have become extremely popular with total AUM growing rapidly to over $3.5 trillion. Unlike mutual funds which only trade at the end of each day when their price is updated, ETFs trade live on the major exchanges just like regular stocks. Similar to index mutual funds, ETFs tend to have very low expense ratios and tend to be more tax efficient. However, they do involve trading commissions, although some brokerages offer commission-free trading. In addition to their low fees, ETFs are favorable to mutual funds for investors who like to trade during the day and place stop orders, limit orders, and/or place short positions as these are possible with ETFs but not with mutual funds. Additionally, ETFs are often available in very niche sectors whereas mutual funds tend to be more general or strategy-specific.
The primary cons of investing in ETFs include bid/ask spreads (i.e., you get less than the ETF’s NAV when selling and/or you pay more than NAV when you purchase) that vary with the liquidity of the individual fund wheras mutual funds always charge and pay NAV minus transaction fees. Additionally, while intraday liquidity is a pro in some cases, it can also be a con if investors lack discipline and trade in and out constantly, racking up transaction fees and short term capital gains taxes.