ETF Education

Should You Buy an ETF or a Mutual Fund?

How to choose between an exchange-traded fund and a mutual fund.

by Morningstar Analysts, 12/07/05

Dear Professor,

Are exchange-traded funds good investments or just a fad?

Frank

With nearly 200 offerings and more on the way, the buzz surrounding ETFs is certainly not dying down. You need to research carefully, however, to determine whether these are worthwhile investments for you. Read on for questions that can help you decide.

Background
Exchange-traded funds are similar to index mutual funds. Like those mutual funds, ETFs try to replicate an index's holdings and performance. The biggest difference between the two is that ETFs trade like stocks. That means that the share price changes throughout the trading day, and you can buy or sell at any time during the day. When you buy or sell a mutual fund, the shares are priced at their value at the end of that trading day.

For more details on how exchange-traded funds work, see Morningstar.com's ETF Center.

Questions to Ask
While an ETF can be a sensible alternative to a mutual fund, there are some drawbacks, too. You should consider the following questions when choosing between an ETF and a fund.

Do you actually need a fund that trades like a stock?

Not all rapid traders and day traders have gone the way of the dodo. For them, the fact that ETFs trade just like stocks can be appealing. For the rest of us, this characteristic probably isn't a plus.

Are you a cost-conscious investor?

At first glance, ETFs may have it all over mutual funds on the cost front. Consider this: The SPDR (Standard & Poor's Depository Receipt) SPY, which tracks the S&P 500 Index, charges 0.11% in expenses. The iShares S&P 500 Index IVV exchange-traded fund is even cheaper at 0.09%. That's just $0.09 for each $100 you have invested--a small fraction of the typical mutual fund expense ratio. Even ultra-cheap Vanguard 500 Index VFINX charges more, with 0.18% in annual expenses. Plus Vanguard charges a $10 annual maintenance fee for account balances below $10,000. On a $3,000 investment, that effectively boosts your annual expense ratio from 0.18% to 0.51%.

The advantages aren't all on the side of ETFs, though. For starters, I chose two low-expense ETFs as examples. Not all ETFs are deals--before buying, be sure to check the expense ratio. And as with a stock, trading boosts the cost of investing in any ETF--you have to pay a broker's commission when you make a trade. Unless you use a cheap broker, invest a large amount of money, and hold for the long term, an exchange-traded fund isn't likely to have a cost advantage over a plain-vanilla index fund. (To make cost comparisons between funds and ETFs, use Morningstar.com's Cost Analyzer tool--a benefit of Premium Membership.)

Do you plan on investing a lump sum?

If you like to dollar-cost average, forget about investing in an exchange-traded fund. Sign up for an automatic investing plan with a mutual fund and it probably won't cost you much extra (you will be subject to fees applied to smaller accounts). But if you invest a modest amount in an ETF every month, the commissions add up. Say your broker charges you $8 per transaction. If you're investing $250 per month (you can invest in a number of index mutual funds for less than that per month), that's a 3.2% bite out of your investment. That means your ETF has to make a fairly significant gain just to get you back to your initial $250.

Are you concerned about taxes?

One return advantage for exchange-traded funds is that they tend to be more tax-efficient than mutual funds. When mutual fund investors redeem shares, a manager may have to sell stocks to meet those redemptions. If the manager incurs taxable gains by selling, that may spell a tax bite for the remaining shareholders. When investors sell ETFs, however, they aren't redeeming shares, they're actually selling them to other investors.

ETFs can make taxable distributions, though. They may hold dividend-paying securities or have to sell stocks to match their indexes. That said, their taxable distributions tend to be minimal and are often less than those of comparable index funds, too.

Are there no index fund options?

It may be that you favor index investing and want to focus on a specific part of the market such as health care or telecommunications. There simply aren't any index funds that track those sectors but there are ETFs that do. Similarly, there are many more ETFs than mutual funds that focus on single foreign countries. It's hard to make the case that such narrowly focused investments are essential to any portfolio, but there are often ETFs for them.

To see the array of exchange-traded funds out there, go to the ETFs section of Morningstar.com. You can look for ETFs by investment style by clicking on the Morningstar style box in the Research section of the page. You can also click on the link to view International ETFs.