ETFs vs. Mutual Funds: You Decide

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Mike D. from Davis, Calif., finally picked a financial planner last month. He and his wife did the interviews, settled on an adviser who works for a name-brand brokerage firm, provided their detailed wish list and waited for some recommendations.

When the adviser suggested a portfolio made almost entirely of exchange-traded funds, however, Mike and his wife got concerned. They had been doing their own investing in mutual funds and now the broker was saying that ETFs are "better."

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"Everything I have heard [from the broker] sounds right," Mike said in an e-mail, "but if ETFs are so great, I don't understand why everyone stays in regular mutual funds. {The adviser] says people won't stay with funds for much longer. Is he right? Are ETFs better?"

Mike's question is one that a lot of mutual fund investors have been asking lately and the answer is not quite as black and white as the public would like. Instead, it can only be answered on a case-by-case basis, matching individual circumstances with the investments to come up with a personalized conclusion.

That said, investors who are looking at funds — and especially index funds — should consider whether exchange-traded issues might be the "better" choice.

Exchange-traded funds are built like a mutual fund, typically an index fund, but trade moment by moment like a stock. While they may seem new to many investors, they actually have been around since 1993, with the creation of Standard & Poor's Depository Receipts, commonly known as "Spiders." For many investors, ETFs piqued their interest in the later 1990s, with the emergence of the "Qubes," named for the ticker symbol (QQQQ) of the Nasdaq 100; during the bull market, technology-oriented investors used Qubes to turbocharge their portfolios.

Today, however, there are ETFs of virtually every flavor. Critics of the business have noted that issuers are slicing off tiny market segments to be the focus of new products, so that an investor can get a fund that tracks, say, nanotechnology stocks or companies that build homes, or can buy into the stock market of, say, Austria or South Africa. And while ETFs currently replicate only index products, many of the new products are tied to benchmarks that are new, unproven and almost actively managed compared to the old standards.

Most people who give ETFs the "better" label point to expenses and tax efficiency, areas where ETFs can beat the traditional index fund, although the difference can be non-existent or marginal depending on the funds involved.

The flexibility of trading throughout the day is a bonus for an investor who is making a short-term play. Investors also can buy ETFs on margin — borrowing money to increase their buying power — or sell them short, betting that the market index is due for a decline.

Lump-sum buying or dollar-cost averaging

The biggest drawback to ETFs for many investors is the simple fact that they must be purchased through a broker. Mike D. didn't say if he was shifting a well-built portfolio or building one for the first time, but the difference is crucial; an investor who has a big chunk of money to invest can do it all at once and incur one commission, while someone who invests regularly will pay the freight with every small step they make.

Even with the low fees charged by online and discount brokers these days, the charges alone make ETFs the wrong choice for the investor who is setting aside money every month or quarter.

"What you save in tax efficiency and in the expense ratio, you lose — and then some — with every trade you make," says Gregg Brewer, director of mutual fund resources at Value Line. "If you have a lot of money to move, like in an IRA rollover, an ETF might be the right choice, but if you are dollar-cost averaging trying to get to where you have a lot of money, the traditional fund will be the way to go."

Finally, the flexibility that some people find as a positive of ETFs also can be a negative, if it leads to quick trades. The savvy traditional index fund investor is playing a buy-and-hold game; the ETF investor buying a thin sector or taking a flyer on the stock market in Malaysia — or even delving into the Qubes — tends to be making short-term, market-timing decisions.

For many people, it's like buying a sports car because it's good-looking and saying you never intend to break the speed limit. Eventually, most drivers will want to see what the car can do. Likewise, an investor knowing that the ETF can be traded on a moment's notice may pull the trigger on a trade when the market is having a bad day.

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Says Brewer: "It's not as easy as saying 'This is better.' You have to look at them both and decide 'Which is best for me?'"

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