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Given how poorly actively managed mutual funds have performed during the bear market, switching to a passive index-based investing model has never made more sense. The combination of lower fees, low turnover, and easy-to-understand strategies make index investing extremely attractive -- especially when tough markets have everyone doubting their ability to outperform their benchmarks.

But once you decide you want to focus on index investments, you still have some choices to make. On one hand, traditional index mutual funds have been delivering market-matching returns for decades. But the up-and-coming investment -- exchange-traded funds (ETFs) -- has made incredible gains in popularity. Some expect ETFs to beat out index mutual funds in market share by 2012. Which should you choose for your index portfolio?

Lots in common
Index funds and ETFs have plenty in common. Typically, you'll find fees that are well below the average for active funds. For example, Fidelity's Spartan 500 Index Investor Fund (FSMKX) has an expense ratio of just 0.10%, and it has delivered long-term returns that have trailed the S&P 500 by almost exactly that 0.10% amount. Meanwhile, the Vanguard Total Stock Market ETF (NYSE: VTI  ) offers an even lower 0.07% expense ratio.

In addition, index funds and ETFs both share many of the same efficiencies. Portfolio turnover tends to be extremely low, because the stocks that each holds usually change only when the underlying index substitutes new components for old ones. That also translates into tax efficiency because index investments can manage their tax liability to minimize taxable capital gains, even during periods when fund investors are taking money out of the funds.

Those similarities may convince you that there's no huge preference between index mutual funds and ETFs. But the particular benefits you're seeking from index investing may push you in one direction or another.

How to choose
In particular, index mutual funds make a lot of sense in these cases:

  • You want to make regular investments. With an ETF, every time you want to make a purchase, you have to pay a stock commission to your broker. Nearly all discount brokers offer commissions of $20 or less, but if you want to invest part of your paycheck every two weeks, you could end up paying more than $500 in commissions if you rely solely on ETFs. If you buy no-load index mutual funds directly from a fund company, on the other hand, you won't pay anything to get in, and many accept relatively small investments.
  • You're using funds for income. Similarly, if you need to sell shares of your funds on a regular basis to cover living expenses, then investing in index funds directly with a fund company may be easier to deal with. Again, each sale of an ETF requires a separate transaction with another commission, so it can get expensive if you're making frequent trades.

On the other hand, ETFs have some particular advantages of their own. The fact that you can buy and sell them at any time during the trading day appeals to short-term investors, but even those with a long-term focus may want to choose ETFs:

  • More targeted investing. It's easy to find index mutual funds that cover broad markets. But ETFs do a great job of letting you pick and choose sectors cheaply. For instance, many investors lately have used the SPDR Financial Select ETF (NYSE: XLF  ) as a one-stop shopping solution for getting cheap exposure to JPMorgan Chase, Wells Fargo (NYSE: WFC  ) , Goldman Sachs (NYSE: GS  ) , and dozens of other financial institutions. Alternatively, the SPDR Energy Select ETF (NYSE: XLE  ) is a quick way to grab a stake in ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and three dozen other energy companies. Both ETFs charge just 0.22% in annual expenses.
  • Transparency. ETFs report their holdings on a daily basis, while index mutual funds may report only once a month or even once a quarter. That means you can detect deviations from the index much more quickly in an ETF than with a mutual fund -- and you can see how the ETF handles events like component changes more easily.

Deciding to go with an index-based investing strategy may not help you beat the market, but you'll do a lot better than many mutual fund investors. Depending on how you invest, though, making the right choice between ETFs and index mutual funds will give you exactly the portfolio you want.

For more on being smart with mutual funds:

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Fool contributor Dan Caplinger owns both index funds and ETFs. He doesn't own shares of the companies mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is an easy choice.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2009, at 9:58 AM, FalseRuler wrote:

    My Question: If one has to think about ETF and the expense entailed, wouldn't it be prudent to invest oneself stategically in the most safe stocks that provide a dividend? Even if the dividend is shrinking, it is still $$ in the stock builder's pocket, isn't it? Wise reading of the forecasts and daily information channels and a look into the past of a desired stock, of course, is mandatory. False Ruler

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