This is a guest post by Neal Frankle.  He blogs over at Wealth Pilgrim about how to find balance in your financial life.  When you finish reading, please consider signing up for his daily posts ?

ETFs better than mutual funds?

Mike Piper recently wrote a great piece on ETF investing right here at Debt Free Adventure.  In it, he did a super job explaining how they work and how they differ from index funds.  If youre like me, youve been reading quite a bit lately about ETFs and why they are or are not better than mutual funds.

Mike makes the argument that since most mutual funds fail to outperform the index, you should buy the index – and the way for you to buy the index is to buy an ETF that matches the index as closely as possible.  Mikes argument is very strong.  Having said that, I think there is a very important issue that often gets lost in this discussion.  As I see it, the ETFs versus mutual funds is a tactical issue.  An important tactical issue… but a tactical issue none-the-less.

What concerns me is that folks sometimes make dogmatic decisions about this (and other issues) and fail to consider strategy – and all the alternatives.  Heres what I mean.  If your strategy is buy and hold – the argument to buy the least cost/better performing vehicle makes all the sense in the world; but what if you arent content to buy and hold?  What if you use a investment strategy like market timing? (Oh, I said it market timing. Bad Pilgrim very bad Pilgrim!)  Believe it or not there are market timing strategies that work.

A case for mutual funds over ETFs

There are millions of people who make money buying stocks – some of which are not buying and holding.  There are huge numbers of people who buy funds that are in (what they identify as) stronger areas of the market and refrain from investing in other areas that are weak.  There is evidence to support that this strategy can make sense for the right investor. It doesnt work perfectly, nothing does but it may be a better fit for investors who want to try to avoid some of the risk and are willing to give up some of the gains.  It would be silly for those using this strategy to ignore mutual funds and only use ETFs .  Why?  Let me give you an example

One strategy ranks all the funds according to their short-term performance (1 year.)  This strategy doesnt care about expenses, but is actually focused on performance.  Since performance is net of fees, it doesnt really matter what the funds charge investors so long as, at the end of the day the performance is good.

You can see how using this strategy can make ignoring mutual funds outright a silly decision.

Its sort of like the people who ran baseball in the 30s and 40s.  They ignored an entire population because of race considerations.  As soon as the sport welcomed African Americans on to the field, the performance sky rocketed.

What is your investment strategy?

Well are you ignoring an entire population of funds at your own expense?  Do you struggle with the decision?  Do you dismiss mutual funds outright because of the expense and tax issue?  Let us know

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