Cheap? Check. Instant diversification? Check. Popular with
novice investors? Check.
All of the above is as true of index exchange traded funds as
of index mutual funds. Given the overlap, choosing between the
share classes can be a bit of a head-scratcher. Here's what you
need to know about when it makes more sense to invest in one over
Flexibility: Active traders like ETFs because they can be
traded like stocks. The structure of index funds, on the other
hand, does not allow for intraday trading or advanced strategies
such as buying on margin. Indeed, ETFs can be used as a core
holding or for arbitrage trade or as a hedging instrument
depending on the investment context, said Ben Johnson, director
of passive funds research at Morningstar Inc.
"They can be used in so many different ways by such a broad
spectrum of investors," he said.
Simplicity: Distinctions between the two share classes blur in
buy-and-hold situations, Johnson added.
"It's a near-perfect convergence in terms of lining up the
pros and cons of each for a long-term investor," he said, adding
that Vanguard's ETFs and mutual funds have "become virtually
indistinguishable from one another."
Still, index mutual funds are often the preferred choice in
this context. You don't need a brokerage account to buy them.
They can be bought from multiple venues, including banks, fund
. ETFs are just appearing in 401(k) plans.
Index funds also make things simpler by reinvesting dividends
automatically. With index ETFs, investors have to decide whether
to hold onto the money, reinvest it, or pick another
Cost sensitivity: When costs matter, ETFs often have an edge.
Index funds can be expensive to trade, perhaps as much as $50 a
pop. But with discount brokerages proliferating online, many ETFs
now trade commission-free or at very low cost.
And ETFs don't throw out capital gains in a bunch at year end
the way many mutual funds do, said Clint Pelfrey, president of
Ohio-based Prosperity Capital Advisors, which manages $365
million in assets. "They tend to be a little more favorable from
a tax standpoint," he said.
Also, unlike many funds, ETFs don't require minimum initial
investments of, say, $1,000 or more. "What you see with ETFs is a
lower bar in terms of the dollar amount needed to invest,"
Diversity: More sophisticated or experienced investors can
endlessly tweak their ETF portfolios to include everything from
very broad asset classes to narrow market niches. Index funds
usually have broader stock holdings.
If you want to build a more nuanced portfolio, ETFs let you
zero in on a more precise target, Johnson says.
Familiarity: For cautious customers, familiarity with a
certain brand may trump all other factors in decision-making.
"They may from a name-recognition standpoint prefer the use of
a particular mutual fund (or fund family)," Pelfrey said.
building a stock-based portfolio
, a shareholder familiar with mutual fund-based models is likely
to stick with the share class for the sake of familiarity. That's
why there are still "10 times as many dollars invested in mutual
funds as there are in ETFs," Pelfrey noted.