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Mutual Funds vs. ETFs: Which Are Better for Retirement Portfolios?

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Related: 14 ETF Tax Facts to Know

Although the tax benefits of exchange-traded funds are not needed in most retirement accounts because their assets grow tax-free, investors could be better off holding index ETFs rather than a combination of index and active mutual funds in those accounts.

Christine Benz, director of personal finance at Morningstar, compared the performance of  conservative, moderate and aggressive model retirement saver portfolios consisting of ETFs with similarly characterized retirement portfolios of mutual funds in 2021 and found that the ETF portfolios outperformed. She developed these hypothetical portfolios for educational and illustrative purposes.

The ETF portfolios are composed of only passive index funds; the mutual fund portfolios include active funds and index funds. The portfolios are designed to showcase different approaches to retirement savings and aren’t intended to mirror each other, according to Benz.

All six portfolios ended 2021 with double-digit gains, which isn’t surprising given that the S&P 500 gained 27% last year, but the ETF portfolios performed better than comparable mutual fund portfolios by 0.9 to 2.61 percentage points, with the biggest gap occurring among aggressive funds.

“Simple was best in 2021, as the exchange-traded fund portfolios soundly beat their mutual fund counterparts, which tilt heavily toward active funds,” wrote Benz.

The mutual fund portfolios were more heavily invested in small- and mid-cap stocks, which underperformed large-caps in 2021, according to Benz.

Small-cap value stocks, however, outperformed other small- and large-caps, and all the ETF retirement portfolios included the high-performing Vanguard Small Cap Value ETF. That ETF outperformed the Vanguard Total Stock Market ETF 28.06% to 25.67% as well as the Vanguard Extended Market Index mutual fund, which learns toward small- and mid-cap growth stocks, and gained just 12.45%.

The mutual fund portfolios also included the Primecap Odyssey Growth Fund, “the main underperformer among the active funds,” Benz told ThinkAdvisor.

The Primecap fund had a 17% weighting in non-U.S. stocks, which didn’t fare so well compared with U.S. stocks. The aggressive mutual fund portfolios had a 42% holding in non-U.S. stocks while the aggressive ETF portfolios had a 34% exposure, for example.

The mutual fund portfolios also had some “idiosyncratic active funds,” which can help performance at some times and hinder it at others, and they had higher fees than the ETF portfolios, Benz said.

The asset-weighted expense ratios of the mutual fund portfolios was 0.49%, more than 10 times the expense for the ETF portfolio. The higher fees are a “hurdle for mutual fund portfolios but not impossible to overcome,” Benz said.

Despite these performance differences, Benz cautioned that she would not “make too much out of short-term performance patterns. To be a successful owner of active funds, you need to be able to tolerate some of these divergences,” she said.

Check out the slideshow above for more on the composition of the three mutual fund and three ETF retirement model portfolios and their performances in 2021.