Depending on various factors and benefits, there are times when an exchange-traded fund, an index mutual fund or an actively managed mutual fund might suit your investing needs.
So let’s start with exchange-traded funds. When does it make sense to consider an ETF?
If you like to actively trade your investments, either with intraday trades, stop orders, limit orders, options or short selling, you should consider using an ETF, as these types of trade orders are not possible with mutual funds.
You might consider an ETF if you want niche exposure to a part of the market (such as a particular industry or commodity) that isn't covered by an index mutual fund, though some actively managed funds might also be available.
Also, an ETF might be right if 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 option of the three. And if you're highly cost-sensitive, consider an ETF because they usually offer the lowest-cost option in terms of annual expenses.
You'll need to keep trading costs in mind, generally looking for a commission-free ETF if possible, and you'll want to double-check to make sure the ETF actually has lower expenses than the available index mutual funds.
What about index mutual funds? When should they be considered?
If you're making small, regular investments, like monthly IRA deposits or using a dollar-cost-averaging strategy, the commissions from trading ETFs could make them more expensive than a no-load, no-transaction-fee mutual fund. However, some ETFs are available commission-free at some brokerages and therefore could be appropriate for small, regular investments.
You could also consider an index mutual fund if it has lower annual operating expenses. When the index mutual fund is the expense leader, you're almost always better off with the index mutual fund than ETFs, especially after considering trading costs on the ETF.
Another time to consider an index mutual fund is when the available ETF is thinly traded. This could lead to large bid-ask spreads, or discrepancies between the price you pay for the ETF and the net asset value (NAV) per share of the fund's underlying securities. Mutual funds, by contrast, always trade at net asset value without any bid-ask spreads.
When it comes to actively managed mutual funds, consider them if:
You want a fund that potentially could beat the market. While there are some actively managed ETFs, there are thousands of actively managed mutual funds that attempt to beat their benchmarks. Most of these funds don't beat the market, but active management at least gives you that opportunity.
Another time to look at active mutual funds is if you want the broadest possible selection of funds. There are currently fewer than 500 index mutual funds and fewer than 2,000 ETFs but more than 7,000 unique actively managed mutual funds.
Ultimately, details matter. ETFs, index mutual funds and actively managed mutual funds can meet your needs in a variety of cases, and by considering these points, you can better choose the right fit when it comes time to invest.