F ollowing the conclusion of my 31-Day Money Challenge. Ive had several people email me about the difference between mutual funds and ETFs (exchange traded funds ). A quick review of opinions online may lead some to think ETFs are better than mutual funds. There is a lot of information suggesting, for example, that ETFs are less expensive and more tax efficient.

As well see, there is some truth to this argument (the link is to an article I wrote some time ago about the advantages of ETFs. Still true today, although the advantages are not as clear cut). But for those focusing on low cost index investing, I believe that mutual funds are the better choice (or at least that ETFs offer little if any advantages). For some speciality asset classes, however, ETFs can be a big help.

Lets dig into the details.

Mutual Funds vs. ETFs

A mutual fund offers an easy way to diversify investments. An investor can buy shares of a stock or bond fund directly from the mutual fund company. The money is then invested in the individual stocks or bonds owned by that fund. For example, with an S&P 500 index fund, money invested is used to buy shares of the companies that make up the S&P 500. By investing in this single fund, an investor gets immediate diversity .

Some key things to keep in mind about mutual funds include:

• Shares are purchased directly from the mutual fund company, not other investors
• When you cash out of a mutual fund, you sell your shares back to the mutual fund company
• The price of a share in a mutual fund is set at the close of each trading day.

On the surface, ETFs are very similar. Like a mutual fund, an ETF typically invests in a broad basket of stocks or bonds. In fact, there are some ETFs that mirror the exact investments of a mutual fund. For example, Vanguard offers an S&P 500 mutual fund (VFIAX ) and an S&P 500 ETF (VOO ). The underlying investments are the same.

The following screenshots show that these two investing options are identical in terms of cost and performance:

Note that in the second screenshot under the ETF you see both a Market Price and a NAV (Net Asset Value). The NAV is identical to the performance of the mutual fund (except at 3-year where its off by one basis point), yet there is slightly more difference with the market price. Well come back to this difference briefly when we talk about the premium or discount of ETFs.

While mutual funds and ETFs share many similarities, there are some key differences. Unlike a mutual fund, an ETF trades much like an individual stock. Shares of ETFs are bought and sold through a brokerage, like one of the many online brokers Ive reviewed here at Dough Roller. There are typically, although not always, trading costs when buying and selling ETFs. Like stocks, the price of an ETF share fluctuates throughout the day when the markets are open. And ETFs are bought and sold between investors, not directly with a mutual fund company.

The Pros and Cons of ETFs

So whats better, mutual funds or ETFs? Generally, ETFs are considered more tax efficient and less expensive. The keyword there is generally, as there are plenty of exceptions as well discuss in a minute. But first, lets understand why ETFs can result in lower taxes and less cost.

First, lets focus on taxes. When a mutual fund manager sells securities in the mutual fund, these sales can generate capital gains that flow to the shareholders. Fund managers work hard to minimize taxes by offsetting any gains with losses. But the result can still be a sizable tax hit to shareholders.

One big reason fund managers sell the underlying investments held in a mutual fund is to generate the cash needed to pay shareholders looking to sell their shares. With ETFs, this isnt an issue. Why? Because shares of ETFs are bought and sold between investors. So the ETF itself doesnt have to liquidate positions in stocks or bonds to cash out selling shareholders.

Second, ETF expense ratios tend to be lower than comparable mutual funds. ETFs dont have the operational expenses that often burden mutual funds. They pass the benefit of lower costs onto investors in the form of lower expense ratios. At least thats the theory.

In practice, Ive found that the types of mutual funds I invest in are no more expensive than comparable ETFs. For example, I invest in the Vanguard Total Stock Market Index Fund, Admiral shares (VTSAX). Vanguard also offers a comparable ETF (VTI). The expense ratio for both investments is the same0.05%.

Now the expense ratio is not the only fee youll pay for either fund. With mutual funds you also have trading costs, which arent part of the expense ratio. With ETFs, you can add brokerage fees, the bid/ask spread, and a premium or discount off of the NAV of the ETF (remember from above that the Market Price can be higher or lower than the NAV. When its higher, the ETF is said to sell at a premium; when lower, at a discount). In the case of VTI, the bid/ask spread (the difference between what a buyer pays and a seller receives) is a whopping 1.28% according to Morningstar .

The point is that not all ETFs are in fact less expensive than comparable mutual funds. Forget about what youve read in other articles. You need to do you homework to determine whether an ETF is in fact less expensive than a mutual fund alternative. In the case of admiral shares of Vanguard mutual funds, I dont see a cost advantage to ETFs.

And as for taxes, VTSAX is as efficient as VTI. In fact, VTSAX has a turnover ratio of just 3%, meaning that the fund sells just three precent of its assets annually. With such a small turnover ratio, the fund is not generating a lot of annual capital gains.

One of the best books on ETFs is called The ETF Book. by Rick Ferri. I had the chance to interview Rick about his book several years ago. You can check out that interview here. where we discuss whether investors should buy mutual funds or ETFs.

The Final Analysis

For low cost index investing, mutual funds are ideal for most investors. They are extremely low cost and generally very tax efficient. Theres just no need to venture into ETFs. For certain speciality asset classes, like commodities, ETFs may be the best option. I invest in PowerShares DB Commodity Index Tracking (DBC) to get exposure to commodities, for example. But beyond this, I stick with mutual funds.

What do you thinkare mutual funds or ETFs the best option?