With over 7,000 stocks listed on the US stock exchanges how do you decide which ones you want to invest in? This is literally the $64,000 question. Do you want to invest in small caps, mid-caps or large caps, growth or value, utilities, technology, financials, consumer discretionary or health care? Beyond that, how do you narrow your choice down to a manageable number of individual stocks to own? How many should you own? What about fixed income investments and foreign stocks? Should we own those, also?

Many individual investors make these decisions based upon “recommendations” from family, friends and co-workers. Often these recommendations are based upon rumor and the person passing on the recommendation has done little research and may not even own the stock themselves. It’s often said that many investors do more research prior to buying a new refrigerator than they do when making a stock investment. Many times the investor will see a stock mentioned in a finance news article or mentioned by someone on CNBC. It’s good to remember that the person who is the source for this information may have motives that are not obvious to you.

There is an alternative to trying to decide which stocks or bonds to own: mutual funds and ETFs. (ETF stands for Exchange Traded Fund.) For purposes of our discussion at this stage we will treat mutual funds and ETFs as the same although there are key differences that you may care about. Both of them allow you to invest in a group of stocks and/or bonds with a single investment. Each mutual fund is organized around a particular type of stock or bond or around a particular investment objective, style or strategy. For example, they may use market cap or industry sector, growth, value, domestic or foreign or they may seek to deliver income more than capital appreciation. Some funds may even seek to profit only when the prices of the stocks it owns go down. The funds are offered by fund companies who employ the use of fund advisors to manage the individual funds. Think Fidelity, Vanguard, T. Rowe Price and Schwab. They each offer a “family” of funds covering the gamut of the above strategies. So, while funds hold the potential to simplify your investment decisions, there are over 8,000 funds available.

The idea here is that the mutual fund has “investment professionals” whose job is to manage the investments to be held by the mutual fund. They make the decision as to which stocks to buy and sell. This is referred to as an actively managed fund. There are also passively managed or index funds. An index fund is designed to match the performance of a market index, for example the S&P 500. The S&P 500 represents the 500 largest, by market cap, stocks being traded. So an S&P 500 index fund seeks to match the performance of the “broad market” as represented by the S&P 500 index. In this case the fund manager doesn’t have to make any stock selection decisions and needs to do only very minimal trading. So, which is better, actively managed or index funds? This is a subject of a great deal of research and debate. I come down on the side of index funds for the following reasons:

– Mutual funds have expenses which are paid by the fund shareholders. These expenses are for compensating the fund manager, paying for their offices and support staff and for their marketing costs. That’s right, the shareholders pay for the fund manager to go out and advertise for more shareholders. Shareholders also pay for the trading costs, broker commissions for buying and selling stocks. There have also been cases where all sorts of other expenses get paid by the shareholder without being actually disclosed. In fact, on your quarterly statement you won’t even see a line item that shows you how much these expenses actually cost you. By their very nature active funds have higher costs than index funds. Typically, the expenses for an active fund will range from 1% to 2% or more. So every year you own the fund 1% or 2% of your money will be siphoned away for expenses. The expenses for an index fund are generally less than 1% and in many cases less than 0.25%.
– Among actively managed funds there are load funds and no-load funds. A load fund charges an up front commission when you purchase shares in the fund. So with a 3% load, for each $100 you invest in the fund, $97 will be used to purchase shares. The other $3 goes to a sales person. This is not the same as a trading fee that is charged to buy and sell stock. This sales commission may go to a financial planner who recommends the fund to their client. The no load fund charges no sales commission.
– The majority of actively managed funds under perform their index peers. You can find much written about this and you will find those that argue that even the published research understates the disparity. In part, this is because the worst performing funds are closed and therefore aren’t really represented. This would mean that the under performance is even greater than reported. It’s true that there are funds that beat the market and in some cases for many years. More often than not the best performing funds in a given year will be among the worst performing funds in the year following. The opposite is generally not true. How can the average investor correctly pick the funds that will out perform the market and continue to do so? The answer is that it’s unlikely that he can.
– Actively managed funds buy and sell stocks throughout the year. In some cases they trade a lot. This is referred to as portfolio turnover. To the extent that this trading generates profits, this results in a tax liability that is paid by….you guessed it, the fund shareholders. At the end of the year, you will receive a tax document that will show your share of these profits that must be reported on your tax return. Since the stocks that comprise an index are rarely changed, the index funds don’t need to trade very much so they generate very little tax liability for the shareholders.

Let’s move on to ETFs. An ETF is an acronym for Exchange Traded Fund. We said earlier that ETFs are similar to mutual funds. Specifically, by their very nature they are similar to index funds. An ETF is created to follow a particular market index. The index could be very broad, like the S&P 500 or it could be related to market cap and style, like large cap growth or mid-cap value or it could be a sector index, like technology or utilities. Because of the way ETFs are structured, they typically have very low expenses. For example, one of the Vanguard broad market ETFs has an expense ratio of only 0.07%.

How do you go about investing in mutual funds or ETFs? For mutual funds, you can open an account directly with the mutual fund company. But if you want to invest in mutual funds offered by multiple fund companies, you would end up with accounts at each one. This becomes difficult to manage. Many brokerage companies offer their account holders access to a broad selection of mutual funds from various fund companies. In this way, through a single investment account you can hold a variety of funds.

ETFs trade just like stocks. If you have an investment account you can purchase virtually any of the hundreds of ETFs regardless of who is the custodian for that ETF. One of the implications of this is that you will pay a brokerage commission when you buy and when you sell an ETF. For example, Charles Schwab charges a trading commission of $8.95 per trade (for up to 10,000 shares). However, Schwab has recently issued its own line of ETFs. These can be traded commission free in a Schwab account.

What’s the bottom line then for mutual funds vs. ETFs? For most investors, a broad market index ETF represents the best alternative with the lowest cost, especially for those looking to build a core investment portfolio. When you consider the higher costs, the underperformance of actively managed funds and the taxable implications of the portfolio turnover in actively managed funds, it makes sense to choose to match the performance of the overall market through broad market index ETFs.