When exchange traded funds first debuted in the U.S. in the early 1990s, many investors and investment management did not realize these products were viable alternatives to mutual funds. Over time, ETFs have become direct rivals to mutual funds. In fact, many investors have pulled their cash out of mutual funds and put that capital into ETFs. That requires some comparison shopping, and this how investors can spot ETFs that are credible replacements for mutual funds.
Look At The Holdings
Assume an investor owns shares in a mutual fund that tracks oil and natural gas companies, but he wants to trade out of that fund for a comparable ETF. An easy, but important, place for the investor to start is by looking at the holdings of the mutual fund and their respective weights within the fund. From there, the investor can evaluate various energy holdings and, very likely, find one that has the same holdings with similar weights to the mutual fund.
Perhaps the biggest reason why ETFs have become a legitimate threat to mutual funds is fees. ETFs typically have much lower fees than mutual funds. ETFs have an average expense ratio of 0.44 percent compared with 0.74 percent for mutual funds, according to the "Wall Street Journal." That means $10,000 into an average ETF will cost investors $44 per year, but that same $10,000 into a mutual fund will be hit with an annual expense of $74.
Most mutual funds are actively managed, meaning there is a manager (perhaps two or three) making buy-and-sell decisions regarding the fund's holdings. On the other hand, most ETFs are passively managed index funds, meaning there is little turnover in the holdings from quarter to quarter. While the concept of active management sounds alluring, most mutual funds consistently fail to beat their benchmarks. That means that if everything else is comparable, investors should turn to performance as a way of finding ETFs that beat mutual funds.
Another excellent way for investors to find ETFs to replace mutual funds -- or as a way of avoiding mutual funds altogether -- is to check for minimum investments. Many mutual funds require investors to pony up a minimum amount of cash to get stored, usually $2,000 or $2,500. No ETFs require a minimum investment, and that can make a significant difference to a capital-constrained investor.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.