Choosing Between ETFs and Mutual Funds

September 21, 2012

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Exchange-traded funds (ETFs) are essentially index mutual funds that trade like stocks, and there are times when an ETF, an index mutual fund or an actively managed mutual fund might suit your needs.

Consider an ETF if:

• You trade actively. If you need to actively trade your investment, either with intraday trades, stop orders, limit orders, options or short selling, you should use an ETF, as these are not possible with mutual funds.
• You want niche exposure. If you're looking for access to a niche of the market (such as a particular industry or commodity) that isn't covered by an index mutual fund, an ETF is likely the best tool, though some actively managed funds might be available.
• You're extremely tax sensitive. In general, both index mutual funds and ETFs are tax-efficient, but ETFs have the edge in most cases. Actively managed funds tend to be the least tax-efficient except for those that are managed for tax-efficiency.
• An ETF can have a lower annual operating expense ratio (OER). In many cases, an ETF might be the lowest-cost option in an asset class in terms of annual expenses. However, this is not always the case, especially as index mutual fund companies have cut expenses. Also, trading commissions on the ETF would mean you need a large enough investment for a long enough time in order for any lower annual ETF expenses to offset the upfront trading cost. That said, some ETFs are available commission-free at some brokerages.

Consider an index mutual fund if:

• You're making small, regular investments. If you're making regular investments, such as monthly or quarterly IRA deposits or a dollar-cost averaging strategy, the commissions from trading ETFs generally make them much more expensive than a no-load, no-transaction-fee mutual fund. Though again, some ETFs are available commission-free at some brokerages—these ETFs would also be suitable for small, regular investments.
• The index mutual fund has lower annual operating expenses. In cases where the index mutual fund is the expense leader, you're almost always better off with the index mutual fund than the ETF, especially after considering commission costs on the ETF.
• The ETF is thinly traded. If the ETF you're considering trades infrequently, this could lead to large bid/ask spreads and discrepancies between the price you pay for the ETF and the net asset value (NAV) per share of the underlying securities held by the fund. Mutual funds, by contrast, always trade at NAV without any bid/ask spreads.

Consider an actively managed mutual fund if:

• You want a fund that potentially could beat the market. While there are a few actively managed ETFs, there are thousands of professionally managed active mutual funds that attempt to beat their benchmarks. Actively managed funds don't always beat the market, but active management at least gives you that opportunity.
• You want the broadest possible selection of funds. There are many index mutual fund and ETF choices, but far more actively managed choices. There are currently fewer than 350 index mutual funds and fewer than 1500 ETFs but more than 6,800 unique actively managed mutual funds.¹

In addition, if you're looking for index management, you should consider the history of the mutual fund's or ETF's returns relative to the benchmark it is trying to track.

If the returns of the mutual fund/ETF and the underlying index are very different, this is called tracking error, which investors in index mutual funds and ETFs generally want to avoid.

If the index mutual fund or the ETF has high tracking error, you might want to look for another fund or ETF.

Ultimately, ETFs, index mutual funds and actively managed mutual funds can meet your needs in a variety of cases, but the details matter. By considering the points above, you can better decide among the three when it comes time to invest.

1. Source: Morningstar as of July 31, 2012.