It depends (a consultant's answer). Actually, I agree with Julian; but, it does depend on the investor. Mutual funds and ETFs do provide the ability to diversify for investors who may not have sufficient assets to diversify on their own.
Investors with a substantial capital base can achieve diversification without having their assets 'pooled' with other people, which a mutual fund does - and you can have more control over tax management(ever try to get a mutual fund manager on the phone?). A separately managed account may be a better option for taxable accounts; but, I do like and index funds for tax-deferred accounts. ETFs can work well for both.
What you should be doing depends on many factors you should discuss with an advisor. Investment options may be a little like medications: Even a miracle drug may not be right for everyone; and all have side-effects. Talk with your doctor.
It depends on the investor, the type of account the funds are held in, and how often you intend to add new funds, but here are a few guidelines to consider:
If you intend to reinvest dividends and make regular new contributions, a low-cost index fund is going to be the best option for most investors. Though I love ETFs and use them extensively in my practice for their flexibility, you have to pay a commission every time you place an order. That can get expensive over time, and funds wasted on commissions are funds not invested. Depending on your broker and/or the mutual fund company, you may not have to pay commissions to buy or add new shares of the mutual fund. If your broker will allow you to DRIP (i.e. participate in an automatic dividend reinvestment plan) for ETF shares, then ETFs would be an equally attractive option.
For larger portfolios, I believe most investors will be better served buying individual stocks, whether they buy them themselves or depend on some sort of separately managed account program. Remember, index investing blindly buys EVERYTHING, be it bad or good. If you are willing to do a little research and have a portfolio large enough for proper diversification, you can build a good, conservative portfolio tailored to your needs. Buying individual stocks also allows you to manage your gains and losses for tax purposes. You can choose when you realize a gain or loss. In a mutual fund or ETF, the decision is not yours.
As Jim Lorenzen mentioned, the assets under management do make a difference in how one approaches asset allocation. Mr. Morris echos our sentiments about the risk in buying individual securities.
In our opinion, Index ETFs are a great, low-cost way to diversify. They are pretty tax efficient too. Even if we were advising a small pension fund with $100-$150 million dollars, we would likely recommend the use of Index ETF's and actively managed institutional share class mutual funds. This is so because we would be unable to afford the managers we would want to hire for active management on a separately managed account basis. These managers have very high minimum investments for their separately managed accounts (often $50 million or more).
To get the kind of diversification we would want to achieve, and get the managers we want, we would have to use mutual funds and/or ETFs. The great thing with index ETFs, is that the individual investor now has access to investments at a cost that was only available to large investors like pension funds just a decade ago. For individuals with larger portfolios, an advisor can add value (over money markets) by investing directly in governments and agencies, and building bond ladders to match the clients cash flow needs.
For the investor that has a small amount of money to invest, they may be initially limited to mutual fund because of the lower initial investment minimums. If you can't afford and Investment Advisor, Vanguard is a good place to look for low-cost mutual funds without loads or contingent deferred sales charges.
Our practice specializes in research, analysis, and portfolio construction using exchange-traded funds because we believe that they are the most flexible, low-cost, transparent, and liquid tool that individual investors can acquire. In addition, the ability to set stop losses make ETFs attractive over a similar index mutual fund. However, no two ETFs are created alike so you have to be savvy at researching the underlying holdings, expenses, index strategy, and tax implications. With the ETF universe expanding at an ever increasing rate, it pays to do your homework ahead of time.
That being said there are several strategies that an ETF just cannot duplicate because of the rules associated with their structure. Most ETFs aren't able to use options strategies or complex trading algorithms that an actively managed mutual fund can. I have found that especially in the fixed-income market, there are numerous mutual funds that are far superior to a simple index ETF strategy because of the expertise of the manager. Bill Gross, Jeffrey Gundlach, and Dan Fuss come to mind right off the bat.
We don't use individual stocks for our clients because we like the instant diversification that ETFs and mutual funds provide.
Personally, a mix of mutual funds and ETF's. I find individual stocks to be too risky. Everyone has a different approach though.
Generally, mutual funds are too expensive and underperform and stocks are too risky for individual investors but there are many exceptions. I recommend using the most liquid and lowest-cost ETFs based on major indexes and find somewhere you can trade them commission free (like Schwab). Ultimately, however, it comes down to having the discipline to implement a successful investing program. Best of luck!
There is really no perfect answer here. As the client, you need to interview the advisors you are considering with an eye towards answering two questions; (1) do you believe that the advisor's strategy makes sense for you, and (2) do you believe the advisor has the resources to deliver.
For example, if the advisor has a strategy defined as being a global investor in individual stocks and bonds, and has a staff of three people, you may need to question how his/her team can actually follow individual securities across multiple continents, languages, economies, etc. If the same advisor says that they are a global investor, but only buys region-specific ETFs, then the strategy is more reasonable. If an advisor is part of a huge, global team with robust research, then either strategy seems doable, but you may want to ask how it will be personalized for you.
Additionally, you need to go with an advisor and strategy that MAKES SENSE TO YOU. If you are not comfortable, it won't work for you. For example, if the advisor only buys US stocks and bonds, but you are a world-aware person who believes that investing globally is the way to go, then this advisor is probably a poor choice for you.
You need to be excited and comfortable with the advisor and his/her strategy. The track record is certainly important. but that is not the only reason to hire, because a track record is like driving a car looking only in the rear view mirror. Ask LOTS of questions, and go with a strategy that is well defined, provided by an advisor who can credibly deliver, and is a strategy that you personally believe in.
Stop asking the wrong question. Wall Street gets you to focus on the investments and not your plan. Right question: Do you recommend we start with a financial plan and match the portfolio to the plan? Right answer: Yes! How would you know what to invest in if you never took a deep dive into your financial life? From there things like portfolio construction, fees, expected return, goofy sales pitches on hot managers that will blow up next year can follow. Warning: understand what you need to do first will limit your desire for stupid expensive investments.
To echo the sentiment of others on this post, it really does depend on the investor, but the right choice is generally a function of expertise and time. The more time and expertise that you have as an investor, the more useful it will be to look at individual securities, because these investments carry the highest possibility of reward, but also generally introduce greater risk to the portfolio.
ETFs and mutual funds are just vehicles to help an individual diversify across a broader set of individual securities so that the return of the portfolio is not as dependent on an individual company. Diversification does come at the expense of potential returns. However for most non professional investors the benefits of reduction in risk far outweigh the reduction of return.
Technically speaking the difference between ETFs and Mutual Funds are not material to most investors. The distinction that is more important is the distinction between active and passive management. To return to the issue of time and expertise, individuals with the time and expertise to vet the managers who are investing their funds should feel more comfortable using active managers which manage money congruently with individual investment philosophies. If you don't have time to vet the managers, then you could consider using a passive index fund (either ETF or mutual fund).
Note: it's very important to remember that it's not possible to ever truly offload an active investment decision. If the active decision is not being made at the security level, it's being made at the asset allocation level and asset allocation determines the vast majority of a portfolio's returns. This is why if you don't have investment expertise it's a good idea to hire an advisor who does. But remember that the advisor is an active manager with his or her own personal investment philosophy. So, like any other active manager, it's extremely important that the individual vets that manager.
Another note in hiring an active manager: It's important to look at fees but only to the extent of making sure they are not egregious. Fees are not the primary determinant of forward returns. It's most important to choose the right manager or index for the individual. Even two low cost index funds can have divergent returns. The Dow underperformed the S&P 500 by ~5% last year. High fees are more a question of the manager's character than ability. It's ok to pay a good investor a reasonable fee, but not an exorbitant one.