Exchange-traded funds have taken the investment world by storm since becoming available in the United States in 1993.
Assets in ETFs soared 58 percent between September 2011 and July, while assets in mutual funds rose 36 percent, according to investment research firm Morningstar.
“They’ve grown a tremendous amount,” said Ben Johnson, director of passive funds research at Morningstar.
ETFs are often compared with mutual funds. Both ETFs and mutual funds bundle together investments – such as stocks, commodities or bonds – to offer investors diversified portfolios.
“They’re like kissing cousins in many aspects, and too often people have segmented ETFs and mutual funds and made them sound like they’re completely different investment vehicles and approaches,” said Joel Dickson, senior ETF strategist at Vanguard. “What underlies both is a diversified, commingled, generally low-cost professionally managed investment portfolio.”
But ETFs and mutual funds are very different in other aspects that savvy investors should keep in mind.
To begin with, ETFs are traded during the day on exchanges and are bought and sold like stocks. Mutual funds don’t trade during the day, and their prices are set at the end of each trading day.
“You have more flexible trading where you could trade it during the day at a price that you know,” Dickson said. “With the mutual fund, you don’t know what price you’re going to pay when you put the order in. You just know that you’re going to get the value of the assets as of 4 p.m. or the next time the net asset value is determined.”
Most ETFs track a particular index. As a result, they typically have lower operating expenses than actively invested mutual funds.
Current figures by Morningstar show that the average expense ratio of U.S. ETFs is 0.67 percent versus 1.25 percent for U.S. mutual funds.
“The math that should be done by most investors is the comparison of the relative cost of each,” Johnson said. “The one thing we know for certain that we as investors can control is the cost of investing. The more I can save for myself and not hand over to a broker or money manager, the more money I’ll have socked away for my own purposes further down the road.”
ETFs don’t have sales loads – fees to buy or redeem assets – but brokerage commissions do apply. A mutual fund may have a sales load.
“You have to be careful with ETFs,” Dickson said. “It gives you a lot more flexibility, but that comes with an additional amount of knowledge that you need to have around how they trade, using limit orders instead of market orders, and what the cost might be.”
How do you decide whether an ETF or a mutual fund is better for you?
Consider ETFs if:
• You’re an active trader. “If you need to actively trade your investment, either with intraday trades, stop orders, limit orders, options or short selling, you should use an ETF, as these are not possible with mutual funds,” said Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory Inc.
• You want to invest in a particular niche business. “If you’re looking for access to a niche of the market, such as a particular industry or commodity, that isn’t covered by an index mutual fund, an ETF is likely the best tool, though some actively managed funds might be available,” Iachini said.
• You’re ultra tax-sensitive. “In general, both index mutual funds and ETFs are tax-efficient, but ETFs have the edge in most cases,” Iachini said. “Actively managed funds tend to be the least tax-efficient, except for those that are managed for tax-efficiency.”
When an investment is described as tax-efficient, it generally means that if you hold it for a long time, you won’t have to pay much in the way of taxes while you hold it. But if you eventually sell it for a profit, you’ll probably owe taxes on any gains you made from the sale.
The reason ETFs are tax-efficient is that most track indexes, meaning the fund manager buys stocks and aims to hold them over time.
“The ETF manager isn’t seeking out overvalued or undervalued stocks, continuously buying and selling stocks in an effort to beat the market,” Iachini said. “Without this frequent buying and selling, there isn’t much chance for an ETF to realize capital gains.”
ETFs share this feature with index mutual funds. But the structure of ETFs allows them to substantially decrease or avoid capital gains, and thus the tax burden on their shareholders.
Buy mutual funds if:
• You’re making small, regular investments. “If you’re making regular investments, such as monthly or quarterly IRA deposits or a dollar-cost averaging strategy, the commissions from trading ETFs generally make them much more expensive than a no-load, no-transaction-fee mutual fund,” Iachini said.
However, “some ETFs are available commission-free at some brokerages. These ETFs would also be suitable for small, regular investments.”
In cases where an index mutual fund is less expensive, “you’re almost always better off with the index mutual fund than the ETF” because of the commission costs, he said.
• You want a fund that potentially could beat the market. “Actively managed funds don’t always beat the market, but active management at least gives you that opportunity,” Iachini said.
Of course, it doesn’t have to be an either-or situation for you. You can have both ETFs and mutual funds as investments.
“Many people use both ETFs and traditional funds in their investment portfolios,” Dickson of Vanguard said.
Whatever you decide, make sure that your decision is compatible with your investment goals and that you invest at the lowest possible cost.