When To Pick Mutual Funds Over ETFs (And Vice Versa)

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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 the other.

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 providers and retirement accounts . 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 investment.

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," Johnson said.

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.

And when 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.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

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