Across a crowded room, index funds and exchange-traded funds (ETFs) are pretty good lookers. Both have low costs, diversification, and approval from Mom and Dad. But it's what's on the inside that counts.

So let's take a deeper look at these two worthy contenders for our investment dollars.

How they work

Mutual funds: Traditional, actively managed mutual funds usually begin with a load of cash and a fund management team. Investors send their C-notes to the fund, are issued shares, and the Porsche piloting team of investment managers figures out what to buy. Some of these stock pickers are very good at this. The other 80% of them, not so much.

Index mutual funds work similarly to traditional ones except that the managers ride the bus and eat sack lunches. (Actually, there are rarely human managers. Most index funds are computer-driven.) More importantly, index mutual funds put money into stocks that as a whole track a chosen benchmark. Because there's less "research" to pay for -- like trips to California to visit that refinery's headquarters (and a little wine tasting... I mean, we're in the neighborhood...) -- index mutual funds generally have lower expenses.

If the fund is popular or its salesmen make it so (yes, funds often have a sales force) it attracts gobs of money. The more money that comes in, the more shares must be created, and the more stocks investment managers (or Hal, the index robot) must go out and buy for the fund.

ETFs: ETFs work almost in reverse. They begin with an idea -- tracking an index -- and are born of stocks instead of money.

What does that mean? Major investing institutions like Fidelity Investments or the Vanguard Group already control billions of shares. To create an ETF, they simply peel a few million shares off the top of the pile, putting together a basket of stocks to represent the appropriate index, say, the Nasdaq composite or the TBOPP index we made up for the kick-off article. They deposit the shares with a holder and receive a number of creation units in return. (In effect they're trading stocks for creation units, or buying their way into the fund using equities instead of money.)

A creation unit is a large block, perhaps 50,000 shares, of the ETF. These creation units are then split up by the recipients into the individual shares that are traded on the market. More creation units (and more market shares) can be made if institutional investors deposit more shares into the underlying hopper. Similarly, the pool of outstanding ETF shares can be dried up if one of the fat cats swaps back creation units for underlying shares in the basket.

The variation in the fund structures mean subtle, but important differences at the end of the chain for individual investors.

A piggy bank sitting on top of a calculator.

Image source: Getty Images.

The business of buying

That's the birds and the bees of ETFs and mutual funds. Now let's take 'em for a spin and see how they handle our money.

Timing trades: With traditional mutual funds, you order your shares and buy them for the NAV (net asset value) at the end of the day. Period. (Unless you're a favored client engaged in illegal, after-hours trading, but that's another story....)

Since ETFs trade like stocks, you can buy and sell them all day long. Though doing that, like any day trading, will likely land you in the gutter searching for loose change, it does have some advantage for the Foolish investor. Limit orders are one. You can tell your broker (or the computerized lackey) to purchase your ETF shares only at a certain price. If the market jumps 3% with excitement over some major world event -- like a peace pact between Britney and Christina -- you can use a limit order to make sure you don't pick up your shares at the top of the soon-to-be-crashing wave of misguided enthusiasm.

Shorting is another possibility. Yes, you black-turtleneck-wearing, world-weary pessimists out there can bet against the index with ETFs, and profit if and when it falls in value.

Making the minimum: If you've ever visited our table of no-load index funds, you might have sprinted away from the computer shrieking. Under the column titled "account minimum," you see numbers as high as $50,000. That's the price of entry for some index mutual funds. Got less than that? Take your money elsewhere. Or rifle the couch cushions for loose change. Or open an IRA, where minimums are generally much lower.

ETFs, on the other hand, have no minimums. You can purchase as few shares as you like. Want one lonely little share? You can get it. Just make sure that you choose your broker wisely so that you don't shell out too much in commissions for your purchases.

Averaging, Joe? A few years back, it might not have made sense to try to dollar cost-average into ETFs. If you were trying to buy a few hundred dollars' worth of a fund once a month, the brokerage fees would have taken a big bite of your nest egg and made a no-load index mutual fund a much better bet because mutual funds do not generally charge transaction fees.

But with the advent of ultra low-cost, or even no-cost brokerages, it's now cost-efficient to make small, frequent purchases of ETF shares. Of course, you'll have to put in the buy orders yourself, as you would to purchase a regular stock.

Options for experts: Though we don't recommend them for beginning Fools, ETFs offer advanced trading possibilities. Options are one. These complex little investments give you the right to "call" or "put" (buy or sell) shares of the ETF at some point in the future for some specific price. There's no calling and putting when it comes to mutual funds.

Dividend differences: Most mutual fund investors take advantage of their fund's automatic dividend reinvestment feature. That saves them the hassle of deciding what to do with the cash that comes their way periodically. If and when the mutual fund pays out a cash dividend, your cut of the dough is automatically reinvested in shares, or partial shares of the fund.

With dividend-paying ETFs, that moolah winds up in your brokerage account instead, just like the dividend on a regular stock. If you want to reinvest that cash, you have to make another purchase -- and you'll get smacked with your usual trading fee unless your broker allows you to reinvest dividends for no extra cost. Many do.

Tax tales

You hear a lot about tax advantages with ETFs. Treat it like barroom gossip: exciting to hear, but probably an exaggeration.

Inevitable, like death: Don't be fooled by vague talk of ETFs' freedom from Uncle Sam. You still need to pay taxes on your own capital gains -- should you be fortunate enough to buy low and sell high -- as well as any dividends you receive. Of course, if your funds are in an IRA or employer-sponsored retirement plan, your gains are tax free until you start collecting. (If they're in a muy Foolish Roth IRA, everything is tax-free.)

Uncle Sam and the Fund: Beginning investors often do not realize that funds themselves incur capital gains taxes, the cost of which is borne (big shocker) by you, the fund holder, even if you don't sell a single share. The topic is complex and boring enough to spawn entire books, so here are the Cliffs Notes:

  • In general, the structure of ETFs tends to avoid the kind of outright selling that would trigger undistributed capital gains and other IRS nightmares. To understand why, think back to the ETF structure. For every ETF seller, there's a buyer.
  • On the other hand, if a flood of investors decide to dump a mutual fund, the fund may need to sell the underlying holdings in order to raise the cash to pay out, and that would bring Uncle Sam with hat in hand. ETFs may also have to drop a few schillings into the taxman's cap, for instance, when the underlying index is changed.
  • Keep in mind that the traditional fund industry and the ETF industry disagree on the extent of the ETF's advantage. Of course, they're competing for your investment dollar, so you should expect squabbles. Still, according to published reports, the Barclays iShares S&P 500 ETF made capital gains distributions while the Vanguard 500 mutual fund did not.

There you have it: Funds v. ETFs. Which one are you going to put in your little black book? If you think ETFs could put a kick in your portfolio, read on for some investing strategies.

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