Mutual Funds, ETFs or Individual Stocks: Is One Best?

Recently an advisor in the field posed the question: “Which is best?  Buying mutual funds, stocks or ETFs?”  The simplest questions can often be the most complicated.  The first concern should be the client’s best interests.  How would you answer the question?


We all know what the terms mean, but from the client’s point of view, it is worth getting a refresher.

  1. Buying individual stocks.  You own a proportional share of the company.  You decide when to buy and sell.
  2. Mutual funds.  This might be better defined as actively managed funds.  This might include traditional equity funds, exchange traded funds with some element of active management and separately managed accounts, also known as managed money.
  3. Exchange traded funds.  Unlike mutual funds, these are listed securities.  I think the example the advisor was asking about was index tracker funds.  Exchange traded funds have the potential above or below net asset value or NAV.

What Are the Considerations When Answering the Question?

“Which is best?” might be better reworded as “Which is better?”  A lot depends on the client.  The client who wants to outsource decision making doesn’t want constant calls about buying and selling.  The client who wants up close and personal involvement is not going to be talking about her index tracker fund over drinks after work on Fridays.

  1. The client wants to be closely involved in day-to-day activity.  Some clients love trading stocks.  It is a major focus of their lives.  Others count research as their hobby.  They do the legwork and decide what they want to buy.  Other clients like the concept of owning specific stocks because they have a great product that is going to meet a present or future need.  They do not want to do the research but will are agreeable to following the recommendations of their financial advisor.  This is not a discretionary relationship.  This type of client would probably like owning individual stocks.
  2. The client wants to outsource stock trading.  The mutual fund options described above are forms of discretionary accounts.  Someone else is driving the bus.  The client wants exposure to the stock market yet has little or no interest in choosing stocks or deciding when to buy and sell.  They are content to own a series of mutual funds or actively managed ETFs.  It takes discipline on the part of the client to sit back and let the managers do their job.  You have seen the DALBAR studies showing the annualized return of the average mutual fund investor is often below the average return of the S&P 500 index or the average return of equity mutual funds overall.  This is because induvial investors tend to act emotionally, often choosing to sell or buy at the wrong times.  Even if the client is agreeable to outsourcing stock trading, it is important for them to be receptive to their advisor’s recommendations, especially in volatile markets.
  3. The client believes no one can beat the indexes on a consistent basis.  Their logic is mutual funds charge management fees.  This makes beating the S&P 500 or other indexes an uphill battle.  They feel their chances of success are better if they “eliminate the middleman” and simply own the index, minus a wafer-thin administrative fee.  If the client buys into the idea, you should be 100% invested 100% of the time, they need to accept there will be years when the major stock indexes are down and they lose money.  They also lose out on sector rotation because they are owning all the sectors all the time.  If the client believes you cannot beat the indexes consistently, take a long-term view and are willing to accept there will be years with a negative return, ETFs that are index trackers are a practical idea.

There is another factor that should not be a consideration when addressing “What is best for the client?”  Not everyone in the financial services industry hold the same licenses.  Someone might hold the license allowing them to sell mutual funds, but not the license to see individual stocks.  The right answer for the client might be to buy and sell individual stocks, but they do not have the right advisor, because they cannot offer that option.    

No one works for free.  There are fees involved.  Several of the services a financial advisor provides are part of the ongoing relationship and do not come with an itemized with individual prices.  Ongoing investor education, portfolio reviews and access to research from the firm’s strategists are examples.

Put another way, different products may be appropriate for different clients, but the value the advisor brings should be a factor in making the decision.

Related: Eight Useful Analogies When Trying to Explain the Market