The Ultimate Fund Question: Mutual Funds, Index Funds or ETFs?

By David Sterman

For many decades, investors had a simple choice:  stocks or mutual funds. If you lacked the time or expertise to pick stocks, mutual funds offered an easy way to play the markets like a pro. But you paid for the services -- often quite handsomely -- for a professional money manager to make the right choices for your fund.

As time passed, investors began to question the system. Are the high expenses associated with mutual funds really in our interest? Or are we just funding lavish lifestyles for underperforming fund managers? After all, once the hefty fees were subtracted, many of the leading mutual funds were unable to do any better than the broader stock market.

In response, Vanguard's John Bogle decided to launch a new kind of fund in 1975: the index fund. Index funds had a simple strategy -- just buy the stocks that make up a major index like the S&P 500. By following this simple recipe, index funds could afford to cut out those onerous fund manager expenses. (Thirty five years later, a wide range of financial firms offer index funds, though Bogle's Vanguard is still the leading player.)

Fast forward to 1993, when investors were presented with yet another choice:  exchange-traded funds (ETFs). ETFs owned investments like an index fund, but traded like a stock. Investors could move in and out of them quickly, and even sell them short if they so desired. The first ETFs focused on major indexes, but there are now hundreds of ETFs focused on specific industries, countries and asset classes. The SPDR Gold Trust ETF (NYSE: GLD) holds gold bullion -- exposure as narrow as that used to be difficult for individuals to get.

So mutual funds vs. index funds vs. ETFs -- is one the best for you?

The short answer is, "No." All three have their place, depending on your investment needs. Let's dive a little more in-depth and see how each instrument can fit into anyone's investing strategy.

Mutual Funds -- Paying for Expertise

Despite their relatively high fees, mutual funds still play an important role in most individual investors' portfolios. Do you want to invest in a certain industry, say, semiconductors? There's a mutual fund for that.

But why not go with the companies with the best prospects and the most reasonably-valued stock prices? Because mutual funds allow you to choose an area to focus on, but with the assurance that the fund manager should be able to pick the best companies within that category.

Remember that when you pay mutual fund fees, you're paying for the fund manager. Fund managers often have extensive industry experience in the industry or sector they invest in. You'll often find a fund manager that started off in the industry that he or she is now analyzing. And that kind of experience can really pay off when it comes time to navigate major changes and advances in technology.

Mutual funds can also help you take advantage of an investment theme that spans several industries. For example, funds that want to capitalize on the baby boomers trend will need to continually find good investments across a wide range of sectors: healthcare, leisure, housing and other industries that cater to this demographic. You won't be able to match that kind of focus with an index fund or an ETF, as I'll explain in the next two sections.

[For more on mutual funds, read our InvestingAnswers Feature: Debunking the 3 Most Widely Believed Mutual Fund Myths.]

Index Funds -- Tracking the Broader Market on the Cheap

When friends ask about investing advice, I always steer them to a nice broad index fund like the Vanguard Index Trust 500 (MUTF: VFINX), which simply owns every stock in the S&P 500. My rationale is that if you've got a long time horizon spanning years or even decades, and you're not interested in trying to predict where the economy is headed, there's no way to precisely know which stocks or sectors will fare well down the road. Instead, exposure to the whole economy, which is broadly represented by the S&P 500, is your best bet.

This kind of index fund will have its up and downs, but should do better than the rate of inflation over an extended period of time. Studies suggest you should expect 6% to 8% annual gains simply by having this kind of broad-based exposure. And here's the big advantage of index funds:  You need not worry that fund fees will take a big bite out of your returns. Vanguard's S&P 500 takes just 0.17% out of your portfolio every year. That's a mere fraction of what many mutual funds charge.

[For more on index funds and diversification, read our InvestingAnswers Feature: Beginner's Guide to Protecting Your Nest Egg.]

ETFs -- Drilling Down, But Not Too Far

Though ETFs have been around for two decades, they've really taken off during the last five years. Want exposure to Egypt's biggest companies? There's an ETF for that. Do you think that owning the nation's largest gold-mining firms is a smarter choice than buying gold directly? There's an ETF for that.

Indeed an argument can be made that choosing the right areas to invest is even more important than the selection of individual stocks. If the economic backdrop is favorable for investing in electric utilities, then the rising tide will lift all boats in that sector. By buying an ETF, you avoid the risk that you picked the one company that turns out to be a dud.

[For more on exchange-traded funds, read our InvestingAnswers Feature: ETF Strategies That Yield Steady Gains.]

The Investing Answer: After all this explanation, here's my takeaway: There's no need to choose among these investment vehicles. Put some money in an index fund and hold it for the long haul, put another chunk in a well-managed, industry-focused mutual fund that gets high marks from Morningstar, and put the rest in a few ETFs that focus on regions or assets that you think hold great appeal. This broad-based approach should deliver solid returns and also brings the benefits of a diversified portfolio.