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Mutual Funds Versus ETFs - Which Is Better?

With progress comes innovation. Exchange-traded funds (ETFs), barely 20 years old, are among the more recent innovation to come off the managed money assembly line. By contrast, the mutual fund dates back to the 1920s, surviving the Great Depression and numerous recessions, including the most recent and, arguably, most severe, of the past several years.

Which Is Better?
It depends upon the type of investor. The traditional, less sophisticated
IRA investor who reallocates strategically, rather than tactically, keeps expenses low and is not a stock picker, may find the process of purchasing shares from a mutual fund company and redeeming them a simpler process. Additionally, plan sponsors' use of mutual funds is well entrenched. Indeed, the ICI reports in its 2011 Investment Company Fact Book that close to $5 trillion is invested in open-end mutual funds within IRAs and defined contribution plans.

Individual ETF investors, on the other hand, tend to be more sophisticated, owning individual securities in both their tax qualified and non-qualified accounts, alike. Institutional investors use them, as well. ETFs trade throughout the day, may be purchased on margin and sold short. ETFs also afford the investor exposure to myriad markets and asset classes. Most are passive investments (track an index), but some offer active and complex approaches.

Institutional managers (
separate accounts, hedge funds) who use leverage, take directional bets, hedge (pairs trading and market neutral strategies) or tactically allocate asset classes, use ETFs that prove to be less expensive and more nimble. These vehicles are more transparent than their closed-end fund (CEF) forebears, which lack the authorized participant, a built in market making device. This feature of the ETF allows for daily creation and redemption of shares, which minimizes differences between the ETF price and its net asset value (NAV). CEFs issue a fixed number of shares, in contrast, which lead to continued differences between the share price and the NAV, creating an arbitrage opportunity.

Other Considerations
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RELATED FAQS
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  3. Do mutual funds invest only in stocks?

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