Why ETFs Beat Mutual Funds

Individual investors' best hope of improving their long-term performance is to keep third parties out of their portfolios. Minimizing intrusions from brokers or money managers keeps your investments between you and the market, with no one else sticking a hand in your wallet for dubious recommendations or "expertise." As online brokerages offer ever-shrinking fees, there's no reason to pay more than $10 per trade anymore -- and even that's a bit steep. But long-term investors may have overlooked another effective way to cut their costs: inexpensive exchange-traded funds, or ETFs.

Traditionally, mutual funds have been the best option for diversifying your long-term holdings. Most corporate 401(k) plans offer a full menu of funds, covering nearly every market and sector. Fund firms have raked in bales of fee income from managing portfolios for this vast array of 401(k) and brokerage account holders, and until former crusading New York Attorney General Eliot Spitzer came along, most charged premium prices for those services.

Since those costs were bundled into the price of the funds, individual investors rarely knew or cared about them anyway, as long as their balances kept rising. But if you were writing a personal check to your fund manager each quarter, you'd probably pay much closer attention to those fees. Thankfully, you may now be able to escape them entirely. There's most likely a lower-cost ETF to replace just about any sector- or index-based fund imaginable. Sure, the occasional fund manager can outperform the index -- our Champion Funds newsletter diligently seeks out those who do -- but the vast majority simply can't, even before you subtract fund expenses.

So why pay more? Why deal with the complexities of A, B, and C shares? Why wait for day's end to learn the price at which your order was filled? Why pay sales loads or early redemption fees, when you can buy an off-the-shelf ETF with nearly identical holdings, instantly executed at wholesale prices?

Particularly in declining markets, mutual funds' higher expenses seem to carry an extra sting -- one you might not notice in a bull market. Mutual funds also suffer from the human factor involved. Portfolio managers add a whole new dimension of risk, since their decisions about your money can be influenced by egos, conflicts of interest, or just plain mistakes.

For all their flaws, mutual fund executives certainly aren't stupid; they've responded to the changing dynamics of their industry by sponsoring their own ETFs. Even though mutual-fund pioneer Vanguard Group always offered low-cost funds to begin with, it's introduced an even lower-cost stable of ETFs in the last few years. Last weekend's Wall Street Journal reported that ETF assets have quintupled over the last five years, compared with a 50% increase in mutual fund assets during the same period.

Today's largest and most liquid ETFs include the Nasdaq 100 (Nasdaq: QQQQ  ) , the iShares EAFE (AMEX: EFA  ) , and the SPDRs 500 (AMEX: SPY  ) . Although the expense ratio on Vanguard's S&P 500 Index mutual fund is now only 0.18%, that's still more than double the SPDRs 500's 0.08%. Which would you rather pay for the next 40 years?

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Fool contributor Michael Mancini owns shares of the iShares EAFE, but of no other fund or company listed above. The Fool has a disclosure policy.