Both mutual funds and exchange- traded funds (ETFs) provide investors with the opportunity to diversify their portfolios without having to pay the prohibitive trading costs that would normally be required, which particularly benefits retail investors, who tend to execute smaller trades.  By investing in either a mutual fund or an exchange-traded fund, the investor indirectly owns the portfolio of securities in which the fund invests and receives his share of the income generated by the fund — dividends, interest, and capital gains — based on his percentage ownership.

Mutual funds and ETFs both offer the investor a plethora of portfolio choices.  There are both mutual funds and ETFs that are designed to replicate a popular domestic or foreign index, such as the S&P 500 Index, a portfolio of 500 of the largest U.S. stocks. You will find some funds of each type that invest only in stocks, only in bonds, only in domestic stocks and bonds, and even only in stocks of companies within a specific industry or within a specific foreign country, to offer just a few other examples.  In short, there are mutual funds and ETFs to match any investment preferences you may have.  This does not mean that you should be indifferent between investing in a mutual fund or an ETF when both target the same investment objective, however.  There are important differences between the two, and the right choice will depend on your specific needs and desires.

Mutual Fund is Better

For one thing, if you plan to use dollar-cost averaging. an investment strategy wherein an equal amount of money is invested in the fund each period, regardless of whether the fund’s price is up or down, a mutual fund is the better choice.  When you invest in a no-load mutual fund, there are no sales commissions involved; you simply buy the shares at their net asset value (NAV) from the fund itself.  Not so with an ETF.  ETFs are sold on exchange floors, and you must pay a brokerage commission whenever you buy or sell shares of an ETF.  Because you will be buying shares regularly, these commissions can quickly eat up your returns.

Secondly, because ETFs trade on exchange floors just like stocks and bonds, you could end up paying more than the underlying portfolio’s value per share for the fund.  This risk is greater the greater the volatility of the market.  In contrast, you can buy or sell (assuming no redemption fee applies) the shares of a no-load mutual fund at its current net asset value, regardless of the market’s volatility.

ETF is Better

On the other hand, when you buy or sell shares of a mutual fund, the transaction is executed at a price that is determined by the net asset value of the fund at the end of the day you place your order.  The market is not continuous, as it is for ETFs.  You can buy or sell ETFs throughout the day for the going market price at the time of your trade.  Furthermore, you can enter limit and stop loss orders when trading ETFs.  These orders allow you to specify a price at which you wish to buy or sell the ETF.   More sophisticated investors may want to place a bet that the portfolio in which an ETF is invested will decrease in value by selling it short.  None of these types of orders are available when trading mutual funds.

ETFs tend to be more tax efficient than their mutual fund cousins, too.  When you sell shares of an ETF, you are usually selling them to another investor, so the fund itself is unaffected.  In contrast, when you sell shares of a mutual fund, you are selling them back to the fund itself, and the fund may need to sell some of the securities in its portfolio to fulfill its redemption requests.  This can trigger capital gain income, which becomes taxable income for the other investors in the fund.  This is not to say that ETFs never distribute capital gains to their investors; it just tends to happen less frequently.

In summary, if you want to dollar-cost average, the clear choice is a mutual fund; however, if you want to be able to execute limit orders, stop losses, and short sales, you can only do so with an ETF.  ETFs can be more tax efficient, but this is primarily a factor when investing in stock funds.