Mutual funds have long been the go-to investment for many investors, thanks to their one-stop-shopping nature. In general, they are actively managed by professionals who do the investment picking for you and, in theory, choose a variety of investments to help reduce risk while attempting to outperform their benchmark. This comes at a price, of course, and sometimes a hefty one at that.
Exchange-traded funds, or “ETFs”, in contrast, are mostly passively managed and were created to closely track companies that make up a particular index, like the Dow Jones or S&P 500. They have gained tremendous popularity in the past decade because of their low-cost and tax efficiency, and are giving mutual funds a serious run for their money.
ETFs have become the investment of choice for more and more professional money managers and are also becoming more common in company retirement plans. Are they right for you? Here are some factors to consider:
ETFs typically cost less because they have lower operating costs than mutual funds do. However, you will pay brokerage commissions to buy and sell ETF shares. So an ETF will be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For others, an ETF may not have a significant cost advantage over a basic, low-cost index mutual fund.
While most mutual funds aim to outperform their respective benchmark and many succeed from year to year, they don’t always succeed over the long term. Many financial experts today agree that investing in a diversified portfolio of low-cost, passively-managed ETFs can be at least as effective, especially for retirement.
ETFs allow you to easily focus on investing in a particular market segment that can be as broad as the total U.S. stock market, or as narrow as Japanese technology companies. Even though there are index mutual funds that try to do the same thing, they may cost more and aren’t always available, depending on your segment of interest.
(Keep in mind that narrowly-focused funds–whether ETFs or mutual funds–can be too risky for many investors, unless they are part of a well-diversified portfolio.)
ETFs are generally considered to be more tax-efficient than mutual funds because they are bought and sold on an exchange and in most cases, simply track an index. Therefore, they are not making frequent trades like most mutual funds that can generate taxable capital gains.
Depending on where you’re investing your money, you may not have access to many—or any—ETFs. For example, some company retirement plans only offer a limited number of mutual funds to choose from. In that case, you may want to stick with index mutual funds, and at least two or three different ones for diversification, if possible.