Mutual funds vs. ETFs

On the investment stage, mutual funds need no introduction. Offering broad diversification, low investment minimums and professional management, these baskets of stocks or bonds have become the answer to the average investor’s portfolio since they debuted in the 1920s.

Mutual funds have the bulk of individual investors’ money, with more than $15 trillion in total assets in May 2014, according to the Investment Company Institute.

But mutual funds do have their limitations. For starters, the actively managed variety passes overhead costs (research and management expenses) on to investors, which eat away at returns.

Funds also distribute capital gains at the end of each year, a taxable event for shareholders — even in years with negative returns. This is true of both actively managed and index funds, though the latter are more tax-efficient.

And, because they get priced once daily at the close of the trading day, funds aren’t flexible enough for investors who wish to take advantage of short-term dips and spikes in the market through intraday trading.

Enter the more sophisticated exchange-traded fund, or ETF, which arrived on the scene in 1993 and has fast become the investment tool of choice for Wall Street and Main Street investors alike.

ETFs, most of which track the performance of a stock or bond index, are much like index funds, with a bit more bling.

Offering broad market exposure, tax efficiency and lower operating costs, they are designed to pick up where mutual funds leave off.

“One of the chief benefits of the ETF is that they tend to be significantly cheaper than conventional mutual funds,” says Sonya Morris, managing director at Harbor Capital Advisors, though some index funds offer competitive expense ratios, she adds.

ETFs are baskets of securities bought and sold on an exchange, not unlike individual securities.

Among the more popular ETFs are “Spiders” (SPY), so named because they track the Standard and Poor’s 500 index of large-cap stocks. “Diamonds” (DIA), meanwhile, track the Dow Jones industrial average, while “Cubes” (QQQ) follow the stocks held in the Nasdaq 100 Index.

ETF prices fluctuate in real time throughout the day, making them well-suited for individual investors engaged in intraday trading.

They can also be bought on margin — using borrowed money — and sold short for those betting on a market slide.

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

Characteristics Index mutual funds ETFs
Generates taxable distributions beyond investors’ control Yes No
Offers broad diversification Yes Yes
Low expense ratio Depends Yes
Triggers brokerage commissions No Often
Allows intraday trading No Yes
Can be bought on margin Yes Yes
Can be sold short No Yes
Appropriate for dollar-cost averaging Yes Depends
Allows reinvestment of distributions Yes Sometimes

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.