The index mutual funds charge more because ETFs outsource some of the functions that mutual funds must perform for themselves, such as trade execution, record keeping and communication with shareholders, says Paul Justice, associate director of ETF research for Morningstar.
Various studies show most active mutual fund managers aren't able to outperform their benchmark indexes. "However, there are some," Payne says. "By paying for the best of breed you can see significantly better performance over time -- 100 to 200 basis points (1 to 2 percentage points) a year. The key is choosing the right manager."
But it's not easy to find a mutual fund manager that will consistently beat the benchmark going forward. It's not easy for financial advisers, let alone individual investors. Remember the warning that past performance offers no guarantee of future performance, though it may be a powerful indicator.
Because ETFs trade like stocks through exchanges, you can buy or sell them at a more exact price than mutual funds, which are priced only once each day, at the close of trading. "If you want to take advantage of a sudden move in the market, ETFs are advantageous," Payne says.
To be sure, "that's a double-edged sword," Justice says. Frequent trading of ETFs will increase your trading costs, raise your tax bill if you're earning short-term capital gains and damage your net worth if you rack up big losses in your trades.
"ETFs can prompt bad investor behavior," says Justice.
And be careful about buying ETFs with an average daily volume of less than 100,000 shares. Low liquidity can raise the price you pay for an ETF and lower your selling price.
ETF tax benefits
But ETFs do carry some tax advantages over mutual funds. As an ETF investor, you generally control when you incur capital gains taxes: It happens when you sell your shares. However, as a mutual fund investor, you have no choice. You'll face capital gains taxes when the manager decides to sell holdings at a profit, whether the fund manager wants to sell or has to because of large shareholder redemptions.
ETFs have been sliced into narrow categories, giving investors the opportunity to gain direct exposure to foreign currencies, for example. Payne likes to use ETFs for "more niche categories," such as small capitalization growth stocks, commodity indexes and a master limited partnership index.
But just to show there are few hard and fast rules on this subject, wealth management firm Evensky & Katz utilizes mutual funds to invest in some esoteric asset classes, such as convertible arbitrage and managed futures. "There aren't ETFs with track records and management talent for these portfolios," says Taylor Gang, a principal at the firm.