Exchange-traded funds have taken the investment world by storm since becoming available in the United States in 1993.
Assets in ETFs soared 58 percent between September 2011 and July, while assets in mutual funds rose 36 percent, reports investment research firm Morningstar.
ETFs are often compared to mutual funds. Both bundle together investments — such as stocks, commodities, or bonds — to diversify portfolios. But they're very different in some respects.
To begin with, ETFs are traded during the day on exchanges and are bought and sold like stocks. Mutual funds don't trade during the day, and their prices are set at the end of each trading day.
"You have more flexible trading where you could trade it during the day at a price that you know," said Joel Dickson, senior ETF strategist at Vanguard.
Most ETFs track a particular index, so they typically have lower operating expenses than actively invested mutual funds.
ETFs don't have sales loads (fees to buy or redeem assets) but brokerage commissions apply; mutual funds can have sales loads.
How do you choose?
Consider ETFs if:
• You're an active trader. "If you need to actively trade your investment, either with intraday trades, stop orders, limit orders, options or short selling, you should use an ETF, as these are not possible with mutual funds," said Michael Iachini of Charles Schwab Investment Advisory Inc.
• You want to invest in a particular niche business.
• You're ultra tax-sensitive. "In general, both index mutual funds and ETFs are tax-efficient, but ETFs have the edge in most cases," Iachini said. The structure of ETFs allows them to substantially decrease or avoid capital gains, and thus the tax burden on their shareholders.
Buy mutual funds if:
• You make small, regular investments. "If you're making regular investments, such as monthly or quarterly IRA deposits or a dollar-cost averaging strategy, the commissions from trading ETFs generally make them much more expensive than a no-load, no-transaction-fee mutual fund," Iachini said. However, "some ETFs are available commission-free at some brokerages. These ETFs would also be suitable for small, regular investments."
• You want a fund that potentially could beat the market. "Actively managed funds don't always beat the market, but active management at least gives you that opportunity," Iachini said.