Choosing between a mutual fund and an exchange-traded fund (ETF) might seem like a difficult decision, but that shouldn’t be the case. If you have the right information, this will be a much easier decision than you likely imagined.

Key Differences

Mutual funds have been around much longer than ETFs and they haven’t changed much through the years. The primary objective is slow and steady returns through diversification. An ETF tracks an industry, commodity, currency, etc. There might be many different holdings within the ETF, but every holding falls under the same category, which means there isn’t as much diversification as in a mutual fund. The upside is that you can see much faster returns. (For more, see: Introduction to Investment Diversification.)

The minimum investment for many mutual funds is $10,000, but you can find minimums that are lower and higher. Mutual funds are priced once per day when the market closes and transactions must be processed directly through the mutual fund. With an ETF, there is no minimum investment. From a technical perspective, the minimum investment is the cost of one share — an ETF trades like a stock. Since an ETF trades like a stock, the price changes throughout the day. This also means that you know where you stand with your investment in real time. Conversely, a mutual fund usually offers disclosure of portfolio holdings monthly or quarterly (and with a lag).

Additionally, with a mutual fund you can’t use margin or limit orders. However, not having an opportunity to use margin can be seen as a positive since it eliminates a potentially dangerous risk. Another plus is that a mutual fund investment doesn’t require a brokerage account. That said, almost every investor has access to a brokerage account in today’s world. (For more, see: Margin Trading: Introduction.)

Fees

Up until this point it might seem as though an ETF is a better investment option, but there’s more to the story. When you invest in a mutual fund, there are no trading fees to contend with. These can add up. For example, if you’re dollar-cost averaging on an ETF and your allocated capital for that investment is $1,000 or less, then those fees are going to play a big role and cut into your potential return. Another negative with an ETF is the bid-ask spread, which is unavoidable. In order to limit this cost, be sure to trade ETFs that are highly liquid. To do this, simply look for ETFs that have high daily average trading volume. A good place to start is with a minimum of one million shares traded daily.  

ETFs usually have lower expense ratios than mutual funds. But be careful of leveraged ETFs, which amplify returns or losses. If you combine that factor with an expense ratio higher than the average ETF expense ratio of 0.46%, you could find yourself in a whirlwind of hurt in short order. Unless you’re an experienced trader, it's best to avoid leveraged ETFs. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)

Small Caps

According to Standard & Poor’s, the only actively-managed category that consistently outperforms the market is small-cap equities. Small-caps are also high-risk/high-reward. In order to maximize your potential, you would need to hire someone to do the research. With large-cap stocks, there is more information available to the public. More importantly, large-cap stocks are bigger ships to turn in bear markets, and they offer strong cash flow generation, dividends, share buybacks and peace of mind. With these factors in mind, passively investing in an ETF that tracks something like consumer staples or large-caps with dividend growth would be simple. You would still need to determine where a specific market was headed over your investment time frame, but this easier than you think (most of the time). (For more, see: Actively-Managed ETFs: Risks and Benefits for Investors.)

The Tax Factor

When you invest in a mutual fund, any taxes incurred from the sale of shares must be paid at the end of the year. You also have to factor in embedded gains. This means you could owe taxes even if the mutual fund lost money since you invested. However, disregard the tax factor if you’re buying a mutual fund for a 401(k) or individual retirement account (IRA). With an ETF, taxes are based on your cost basis. (For more, see: Mutual Funds that Reduce Your Taxes.)

The Bottom Line

Still not sure which is a better option? That’s because one is not better than the other. Your decision should be based on your investment goals. If you have a long-term game plan, consider a mutual fund. If you’re an active trader or an involved retail investor, consider an ETF. (For more, see: Are These Your Best ETF, ETN Bets for 2015?)

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