Stocks, Bonds, Mutual Funds, or ETFs?

I was talking to a friend about investing, and they asked a seemingly-innocuous question: "Do you recommend people invest in stocks, bonds, mutual funds, or ETFs?"

My face froze for a bit, as I tried to come up with a short, glib answer. When they started to look concerned, I replied, "Well, there's actually not a simple answer. What if I wrote up a blog post and pointed you to it?" 

So here we are.

To answer the question, first we have to recap what each of those are. You can skip over the ones you're already familiar with, and go straight to the interesting bits, as you see fit.

Stocks

Stocks, or "equities", are ownership shares of a company. By owning stock in a company, you become part-owner of the company itself. And yes, that does mean that you theoretically have a say in what the company does! I say "theoretically", because you only have as many votes in major company decisions -- such as electing the board of directors -- as you have shares of stock. Also, as part-owner, you get to collect any extra profit the company throws your way, in the form of dividends.

Generally speaking, stocks are more volatile than bonds, but they have a higher rate of return over the long term, due to the volatility premium. 

Bonds

Bonds are, simply put, loans. You might be loaning to the US Treasury, the City of Austin, or Goldman Sachs, but the idea is the same: the entity you're lending to pays you interest on your loan. The value of the bond will fluctuate over time, especially as interest rates change, but not nearly as much as stocks do, and in the meantime you're collecting a steady stream of interest. Of course, lower risk generally means lower reward, and bonds are no exception.

Mutual Funds

Mutual funds are, simply put, "baskets" of many different stocks and/or bonds and/or other securities. The value of a share of a mutual fund is directly determined by the NAV (net asset value) of the underlying securities. As of 2016, there were 9,511 mutual funds in the United States, each of them (in theory) different. One might invest in US Treasury bonds, another in international stocks, another in collateralized commodities futures, another in real estate investment trusts, and another only in environmentally sustainable companies. 

While you can buy and sell mutual funds, the transactions don't function quite the same way as stocks and bonds -- for example, trades occur at the end of the day, so there's no such thing as "day trading" mutual funds.

ETFs

Exchange Traded Funds are pretty much what it says on the box: they function a lot like mutual funds, but they're traded on exchanges just like stocks and bonds. Because the transactions do function the same way as trading stocks and bonds, you can e.g. day-trade them, if you want to. There are a few other differences from mutual funds that we'll discuss later.

So...which is best?

As you can see, because stocks and bonds have different places on the risk/reward spectrum, and mutual funds and ETFs actually contain stocks and bonds within them, the idea of "which is best" is a little complicated. Let me break it up into several different "which is better" questions.

Stocks or bonds?

Answer: neither. In fact, I recommend most portfolios have both. Stocks have higher volatility but higher long-term returns; bonds have lower risk, but lower reward. By having some of both, you can "dial in" exactly how much of each you want. It all depends on your risk tolerance and risk capacity.

Individual stocks or mutual funds/ETFs?

Answer: mutual funds/ETFs. Some investment managers will fight me on this, and stockbrokers will especially, since they're paid to sell (individual) stocks. However, research consistently shows that the market is getting more efficient by the day, making it harder and harder for even the most brilliant people in the world -- who do this every day, for a living, and are extremely well-compensated for it! -- to consistently pick individual stocks that are "mispriced". 

The good news is that you don't have to. There are excellent mutual funds that will give you a broadly diversified portfolio of stocks, and for very cheap -- as of 2018, Vanguard's funds have an average expense ratio of 0.18%. Now, there are a lot of expensive, less-than-excellent  funds out there, but if you stick to good fund managers like Vanguard and Dimensional Fund Advisors, you'll do just fine. (For ideas, check out this 2018 survey on mutual fund companies advisors recommend to other advisors.)

Individual bonds or mutual funds/ETFs?

Answer: mutual funds/ETFs. Again, some folks would fight me on this. "I can hold an individual bond to maturity", they would say, "and be guaranteed to get my money back, assuming the lender doesn't default. A mutual fund's value is constantly changing." That's all technically true, but it misses the point. Yes, a bond fund's value fluctuates over time -- but so does an individual bond! And sure, as long as you hold the bond to maturity, you'll "get your money back" -- but what do you do with that money? You'll probably reinvest it, right? And you don't want to have all your bonds maturing at the same time, so you'll probably buy several that have staggered maturities. This is exactly what bond funds do: they hold many individual bonds and reinvest the money as they mature. The only difference is that you can actually see the value fluctuating over time.

And just like with stocks, the bond market is quite efficient, so trying to pick bonds that will outperform is a loser's game -- you might get lucky for a while, but eventually the house wins.

Mutual funds or ETFs?

Answer: it depends. Let's break it down.

ETF expense ratios are often lower. If you take the same Vanguard fund -- for example, Vanguard Large-Cap Index -- the normal mutual fund ratio is 0.17%, and the ETF fund ratio is 0.05%. However, if you're putting at least $10,000 into the mutual fund, you can buy "Admiral shares", which have the same 0.05% expense ratio as the ETF. Fidelity and other mutual fund companies do this, as well, but if you're only investing a little, the ETF is definitely the cheaper option.

ETFs are more tax-efficient than their mutual fund counterparts. Simply put, this is because whenever someone wants to sell their shares of a mutual fund, the manager generally has to sell some of the underlying securities, which means capital gains for all of the mutual fund shareholders. (This is one of the reasons why Dimensional Fund Advisors only works with investment managers who agree with their long-term approach.) However, with ETFs, the underlying structure is set up so that no such sales have to take place. Of course, if these mutual funds are sitting in an IRA, you don't care, since the growth isn't being taxed anyway.

ETFs often have lower commissions, but are subject to "bid-ask spread". Whenever you buy or sell a stock, bond, mutual fund, or ETF, your custodian -- be they TD Ameritrade, Fidelity, Scottrade, or whoever -- generally charges a commission. Often, these commissions are higher for mutual funds than for ETFs. However, ETFs are subject to a "bid-ask spread", which means that you sell for slightly lower than market price and buy for slightly higher. The middleman's got to get their cut! Note that while commissions are a fixed price, for example $10/trade, bid-ask spreads are effectively a percentage of the transaction. The bigger the transaction, the more the bid-ask spread dominates the transaction cost.

ETFs are slightly more complex to trade. When you're selling a mutual fund, it's pretty straightforward: you say how much money you're putting into or taking out of the fund, and at the end of the day, they take care of it for you. In fact, you can do an "exchange", whereby you take money out of one fund and put it in another (say, when rebalancing), and the two transactions occur smoothly and simultaneously.

ETFs, however, trade like stocks, which means that when you place the buy or sell order, you specify the number of shares. Also, you either specify the price at which you're willing to buy or sell, or you indicate that you're willing to go with the current market value. (I can hear traders crying out in horror at the thought of not putting in a limit order. I know, guys, I know -- I'm just putting it out there!) It can be a bit unsettling if you're not familiar with the process.

Also, if you're rebalancing, you have to sell, wait for the trade to settle (generally a couple of days), and then buy, which can be annoying. Not to mention the fact that because you're dealing with shares, not dollars, you'll generally end up with leftover cash in your account, sitting there uninvested. Though the opportunity cost is generally small, it grates on my engineering sensibilities.

Some funds aren't available as mutual funds. Remember DFA, with that long-term approach? Unsurprisingly, they're uninterested in the idea of people day-trading their funds, so they don't offer ETF versions of any of their funds*.

What I Do

So as you can see, depending on your situation, you could go either way when it comes to mutual funds or ETFs. Speaking personally, this is what I do:

• When implementing a DFA portfolio, I use mutual funds, of necessity.

• When implementing a small non-DFA portfolio, I use ETFs. I don't want to have to worry about e.g. Admiral fund minimums, I've got systems in place to handle the added complexity, and the lower commissions generally outweigh the bid-ask spread.

• When implementing a large (generally, $1MM+) non-DFA portfolio, I use tax-efficient mutual funds where I can, and ETFs otherwise. I can get the same expense ratios as ETFs by purchasing Admiral-type funds, and the commission difference is generally outweighed by the bid-ask spread, so it comes down to the tax efficiency.

• When recommending a portfolio to a client to implement, I generally recommend mutual funds, because of their simplicity. I prefer a slightly less-optimized portfolio that actually gets implemented well over an "iron butterfly" that looks pretty but doesn't fly! (Of course, the client is welcome to use ETFs if they want, but I leave that as an exercise to them.)

So there you have it: a 1700-word answer to a 12-word question. How about you? Has this sparked any questions on the topic of investment implementation?

* EDIT: A colleague of mine pointed out that while DFA doesn't directly offer ETF versions of their funds, there are ETFs out there for which DFA is a sub-advisor. For example: John Hancock Multifactor ETFs.