Which is the better investment vehicle, ETFs or mutual funds? Many news media focus on minor details between the two, and compare the fee structures, asset values, turnover, trading cost, etc between them, but never mention two most important factors making them so different: liquidity and performance.
Liquidity is the top priority in any investment decision. Illiquid investments can create significant loss if timely stop loss can’t be applied immediately. Mutual funds only allow share holders to trade once a day. Many mutual funds in 401k, 403b, variable annuities, variable universal life, and 529 plans place more strict restriction, sometimes allowing trade only once a month.
Let’s look at what happened on Monday, September 15, 2008, one day after Lehman Brothers went bankrupt on Sunday.
VIX shot up significantly at market open, and it was obvious that it was not the time for long term investment.
S&P 500 was down significantly at opening. ETF investors had plenty of time to cut the loss to get out of the market. Mutual fund investors had to decide whether to cut the larger loss at the market close or continue to hold on to it, hoping it rebound the next day, which later created even larger loss.
On Oct. 19, 1987, S&P500 dropped 20% from open to close in one day. No one knows if it will happen again in the future, but using ETFs keeps the option open to cut the loss at 5% or even 10%.
Performance is another top concern for equity investors. There are more than 20,000 mutual funds in US alone. Yahoo! provides mutual funds performance data at: http://biz.yahoo.com/p/tops/all.html. According to the site, as of July 31, 2008, the top-performing mutual funds are:
Yahoo! also provides free ETF data at: http://finance.yahoo.com/etf/browser/mkt. The 3-month and 1-year performance data as of July 31, 2008 speak the different quality of managers between ETFs and mutual funds, despite there are only 807 ETFs as of today according to this site.