Exercise: Should I buy an ETF or a Mutual Fund? – Investing does not have to be difficult or complicated. Some advisors make it sound complicated because they want you to pay them handsomely for their wisdom and advice. However, if you know five words and their meanings, you can make many worthwhile investment choices on your own. The five words are: Quality, Diversification, Cost, Earnings, Dividends.

Here are the simple questions to ask about each of these.

QUALITY – Does this fund contain investments that are likely to be around in ten years?

DIVERSIFICATION – Are there at least 50-100 different companies in this fund? Does it include large cap and mid-cap companies and companies that are involved in different areas of the economy (consumer, energy, manufacturing, technology, health care.)

COST – What will this investment cost me to buy it? What will it cost for the first ten years I own it? As a rule of thumb, any investment that meets the other four criteria with an expense ratio of no more than 0.10% is an appropriate choice.

EARNINGS – Are the earnings from this investment growing? (This is easier to do for an individual stock, but you could look at the top five investments in any fund and see if each of them has growing earnings!)

DIVIDENDS – Will I be paid more every year that I own this investment? After I subtract the fees/costs, how much is my actual dividend? For example, if the annual expense ratio is 0.40% and the dividend yield is 0.90%, then you are only receiving 0.50%, not 0.90%. The fund gets a sizable chunk of your income.

 

EXERCISE – Now we can compare to very good investments. One is a index mutual fund from Vanguard (VFAIX) and the other is a good ETF from iShares (DVY) with a mid-cap focus.

QUALITY – Does this fund contain investments that are likely to be around in ten years? – DVY – Yes: examples include McDonald’s; Lockheed Martin, Caterpillar and Chevron.  VFAIX – Yes; This fund holds more than 400 quality companies including JP Morgan, Bank of America and other businesses shown on the image below.

DIVERSIFICATION – Are there at least 50-100 different companies in this fund? – DVY – Yes, there are almost 100 companies in this ETF. They are primarily mid-cap and many are utilities, consumer discretionary, financials and industrials. VFAIX – Yes, there are over 400 investments, but they are focused on the financial sector. This fund includes, large, mid and small cap investments.

COST – What will this investment cost me? – DVY – The expense ratio is 0.39%. I think that is a bit high, but it makes sense given the dividend yield and the dividend growth. This is also a mid-cap fund, so iShares feels like they can charge more for this ETF with more active management. Fidelity does charge to trade this ETF ($4.95 per trade) but you can automatically reinvest dividends at no additional cost. VFAIX – The expense ratio is 0.10%. Very acceptable. Unfortunately, you cannot trade this index fund on Fidelity Investments, and the comparable Fidelity funds have an unacceptable expense ratio. So here is an argument for opening an account at Vanguard: Vanguard generally has many good index funds with very low expense ratios.

EARNINGS – Are the earnings from this investment growing? – I won’t take the time to research this for DVY or VFAIX. However, earnings for quality companies have been increasing. In addition, both funds are seeing growth in dividends, which generally can mean that earnings are growing to support the increased dividends. Company boards are not eager to raise dividends that may not be supported by future earnings.

DIVIDENDS – Will I be paid more every year that I own this investment? – The short answer for both DVY and VFAIX is Yes. You can check this out on the following web site: https://www.etfreplay.com/yield.aspx

CONCLUSIONS: I would not buy DVY and say “I have good market cap diversification.” DVY is a very good mid-cap dividend-growth investment with reasonable costs. I would not buy VFAIX and believe that I was getting good sector diversification, but I would buy it if I thought increasing interest rates and lower corporate taxes will improve the bottom line on the financial sector.

Here are the top investments (extracted from Weiss Ratings) in VFAIX: