Question

If you had $5,000 to invest, would you rather put your money in a mutual fund, an index fund, or an exchange traded fund (ETF)?  Carefully explain the pros and cons of each indirect finance method.               

Answer 1

In which fund to invest is a subjective question and depends on the risk-return profile and expectations of the investor.

Mutual fund

Pros

• Actively managed fund - Since mutual funds are actively managed, the highly skillful fund managers strive to generate alpha over the index. Hence, the returns expectations are generally higher in case of mutual funds
• Diversification - Fund managers diversify into various asset classes, thus reducing the overall risk profile of the fund for a given level of expected returns.

Cons

• Since, these are actively managed, the management fees or commission is higher in case of mutual funds
• Historically, it has been observed that active management of funds has hardly been able to beat the index or market returns.

Index fund

Pros

• These are the fund which tracks an index. These indexes are low-risk funds and provide steady growth to the investors
• Low fees- Since there is no active management, commissions or management fees is lesser than actively managed funds

Cons

• No very high returns or no alpha is generate -Since the risk associated is less, the returns cannot be expected to be higher than the market returns
• Also, index funds lack flexibility in the sense that fund managers need to stick with the index stocks and not make any adjustments for better returns

ETF's

Pros

• ETF's trade intraday, hence, unlike mutual funds, they do not trade at NAV and hence bought and redeemed at price at which they are trading. Hence, there is price transparency.
• The expense ratio or the commission is even lower than the index fund.

Cons

• Like index funds, ETF's have lower flexibility and lower returns.
• ETF's are close-ended, and hence cannot be invested in a SIP and hence the advantage of averaging cannot be enjoyed.