Mutual funds vs. ETFs

Another plus of ETFs is that, because they don't have to sell underlying securities to meet redemptions, they rarely distribute taxable gains to shareholders. ETF investors sell shares to other investors.

Yet, no investment vehicle is without its weaknesses.

With a few exceptions, any time you trade an ETF, notes Morris, you pay a brokerage commission, making them less attractive for active traders and anyone using a dollar-cost average investment strategy -- those who buy into a position with small, periodic investments over time. (Some online brokers do offer commission-free ETFs, however.)

At the same time, the flexibility to trade ETFs like stocks can also become a pitfall for some investors. "Unfortunately that encourages investors' worst instincts -- to chase past performance," says Morris.

Despite their growing popularity, ETFs remain largely unavailable to investors through 401(k)s and other employee-sponsored retirement plans, which often restrict their offerings to mutual funds.

Characteristics of index funds and exchange-traded funds

CharacteristicsIndex mutual fundsETFs
Generates taxable distributions beyond investors' controlYesNo
Offers broad diversificationYesYes
Low expense ratioDependsYes
Triggers brokerage commissionsNoOften
Allows intraday tradingNoYes
Can be bought on marginYesYes
Can be sold shortNoYes
Appropriate for dollar-cost averagingYesDepends
Allows reinvestment of distributionsYesSometimes

Those considering new investments for their personal portfolio, however, should weigh the pros and cons of ETFs and mutual funds against their need for tax efficiency and flexibility.


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