Mutual Funds vs. ETFs: Which Is Better?

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Mutual funds have given millions of Americans the opportunity to invest modest sums of money in well-diversified portfolios of stocks, bonds, and other investment assets. But more recently, exchange-traded funds have gained in popularity, gathering more than $1 trillion in assets and threatening the dominance that mutual funds have enjoyed for decades.

So if you're thinking about investing and aren't sure whether to go with mutual funds or ETFs, how can you figure out which one is best for you? Here's are some things to consider.

1. Trading access.
Mutual funds and ETFs differ in how you buy and sell shares. With mutual funds, you can only make purchases or sales as of the close of the trading day, with fund prices set on a daily basis based on the closing values of the assets they hold.

ETFs, on the other hand, are available for trading throughout normal market hours, meaning that you can buy or sell shares anytime the market is open. That gives you more flexibility to make short-term trades based on particular market events, rather than having to wait until the end of the day, by which time conditions may already have changed.

For long-term investors, being able to trade every minute may not be very important. If you have more of a short-term focus, though, ETFs will make you better able to respond quickly whenever you want to buy or sell.

2. Active management.
Mutual funds come in two types: actively managed funds and index funds. As their name suggests, index funds use a mechanical approach to investing, simply buying all the stocks in a given benchmark index or taking a representative sample of those stocks. But other funds have money managers who use their judgment and experience to make deliberate choices about which investments to include in the fund.

At this point, most ETFs use the index approach, with SPDR S&P 500 (NYSEMKT: SPY  ) and Vanguard Emerging Markets (NYSEMKT: VWO  ) currently the two largest index-tracking ETFs. Although some actively managed ETFs exist, most notably the Pimco Total Return ETF (NYSEMKT: BOND  ) that bond guru Bill Gross manages, the SEC has been slow to approve actively managed ETFs. So if you want active management, traditional mutual funds are your better bet, at least for now.

3. Cost.
The costs of trading and owning mutual funds and ETFs vary widely, but they come from different sources. Some mutual funds charge upfront commissions to buy them, known as sales loads, that can cost you 3% to 5.75% of your investment or even more. But "no-load" mutual funds have no fee to buy shares. Fund shareholders also pay ongoing management fees, with costs tending to be higher for actively managed funds -- in the 1% range on average -- and lower for index funds, with some index funds charging 0.1% or less annually.

With ETFs, on the other hand, your broker will charge you a standard commission every time you buy or sell shares. Some brokers waive their commissions for certain ETFs, making them a lot more economical to use, especially if you make frequent transactions. ETFs also have ongoing annual management fees that can vary greatly. For instance, the Vanguard Total Stock Market ETF (NYSEMKT: VTI  ) charges just 0.05% in annual fees, while some other ETFs charge 1% or more per year.

If you intend to make regular additions to your portfolio, having to pay commissions or sales loads every time you buy is costly. Unless you can find ETFs you like with no-commission deals with your broker, you'll likely save money going with index mutual fund substitutes for your portfolio.

Make the smart choice
Mutual funds and ETFs both have attractive traits to consider. Which one's better for you depends on your own individual investing style, but either one can serve you well with your investing needs.

To learn more about a few ETFs that have great promise for delivering profits to shareholders, check out The Motley Fool's special free report "3 ETFs Set to Soar." Just click here to access it now.

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