Ready to Dump Your Funds

Question of the week:With all the news lately about improper practices in the mutual funds industry, I'm about ready to dump my funds completely. Do you have any suggestions for a good alternative place to put my money? --S.C.

Dear S.C,

Given that Americans have $7 trillion invested in mutual funds, and a steady stream of troubling news from the industry watchdogs, I'm sure there are many other investors out there who are having the same response. When we asked members of the Armchair Millionaire community for their reactions to the mutual funds mess, we heard a range of opinions. Here are just three:

Voting with his feet. "Although I only have a money market account with Strong, and was not affected by Dick Strong's market timing of his own company's funds, I am going to close the account and put the money with a company that is more ethical. I also closed a Janus account for the same reason. If more investors voted with their feet, fund companies would soon get the message." --John R.

Wait and see. "So far I am hanging on to good quality mutual funds, but I am watching and listening ..." --Les

Sticking with funds. "I have left my mutual funds alone, intact and where they were for the most part. I think this is just a 'bump in the road' and that fund investing will continue as always. --Alana F.

In terms of alternatives to mutual funds, there is one choice that offers the easy, instant diversification that makes mutual funds so attractive. Exchange-traded funds (or ETFs, for short) look like an index fund, tracking the securities of a particular equity or bond index. However, they trade just like stocks, so you need to buy them through a broker. Perhaps the best known ETFs include SPDRs (often called "spiders"), which track the S&P 500, and DIAMONDS, which track the Dow Jones Industrials.

My guide gives you a look at the most important differences between ETFs and mutual funds in the key areas you should consider.

The Armchair Millionaire's Guide to Mutual Funds vs. ETFs

• Expenses. The annual expense ratios for mutual funds can range from a low of about .2 percent for the best index funds on up to 2 percent or even higher for some actively managed funds. ETFs are generally much more cost-efficient, with expense ratios ranging from about .1 percent up to just .6 percent.
• Trading costs. If, like me, you're a big believer in the value of investing small amounts on a regular basis (called "dollar cost averaging"), ETFs are problematic. While no-load funds let you buy shares as often as you wish without paying a sales commission, you do have to pay a brokerage commission every time you buy ETF shares. These trading costs could easily wipe out the advantages of the low expenses of ETFs.
• Selection. With the thousands of mutual funds available, there's one to suit virtually every investor's taste, from the broadest index funds to specialty funds investing in just a single industry or country. But there are all kinds of ETFs, too. There are ETFs that track all the major stock indexes, including large, mid- and small cap indexes, growth and value indexes, global indexes and bond indexes.
• Flexibility. Mutual funds usually require a minimum initial investment (typically ranging from $500 on up to $3,000 or more), but make it easy to automatically make subsequent investments. You can invest in funds through a financial advisor, broker or directly from many fund companies. ETFs, like stocks, are bought and sold throughout each trading day, and can be sold short or bought on margin. There is no minimum investment, but you will need to have a brokerage account set up to buy ETFs.
• Taxes. Because of the turnover of investments held by mutual funds, you may often have to pay taxes on capital gains, even if you don't sell any shares. ETFs, on the other hand, are extremely tax-efficient, though you will have to pay taxes on capital gains if you sell your ETF shares for a profit, just like you would with any stock.

THE BOTTOM LINE: It's certainly not reassuring to hear about big names in the fund industry being investigated for possible wrongdoing. However, you should not simply react and pull your fund investments altogether. By being aware of your alternatives, you can try them out and come up with your best solution.