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Why I Like ETFs Better Than Mutual Funds

Nov 24, 2015

When I came of investment age, there were no such things as exchange traded funds. Mutual funds, yes. ETFs, no. So when ETFs began getting popular, I had little interest in them.

I knew ETFs were good trading vehicles; however, I was not an active trader.

But in the summer of 2014, I started rearranging some family investments held in a brokerage house and discovered that transaction fees to buy certain index ETFs were much lower than for equivalent index mutual funds. The management fees were lower, too.

So now, my portfolio is bi-cultural. My funds are still primarily mutual funds, but ETFs are getting to be a significant part of my family’s holdings.

People often think that mutual funds and ETFs are pretty much the same thing: They both have the word “fund” in them, after all. But they are very different things.

If you are new to the ETF game, as I was, here’s what you need to know:

Mutual funds—or to be technical, open-end mutual funds—are investments that you buy or sell at net asset value (NAV) in a transaction that you place while financial markets are open, but that is executed after the markets close. (You may pay a markup over NAV if you’re buying a load fund—the markup is the equivalent of a broker’s commission—or take a haircut if you’re selling).

You place mutual fund orders in dollars, not in shares. You buy your shares from the fund, and sell them to the fund. You don’t know what price per share you’ll pay or get, because you place your order before the fund has had time to calculate its net asset value per share. (It does this by adding up the value of everything it owns, and dividing by the number of shares outstanding.)

An ETF, by contrast, trades like a stock and you buy or sell it during trading hours. Dealers make markets in ETFs, typically getting a bit above net asset value when you buy, and paying you a bit less than asset value when you sell. You don’t deal with the fund company directly.

You have to buy a specific number of ETF shares—you can’t specify a dollar amount. If you have a fixed amount of money to invest, you can’t use every penny to buy an ETF, the way you can when you’re buying a mutual fund.

(A hint: If you want to buy both a mutual fund and an ETF with proceeds from liquidating an investment, buy the ETF first. Then use what’s left to buy mutual fund shares.)

Because you deal with your mutual fund directly when you buy or sell shares, you don’t have to take any safeguards to avoid getting gigged by market glitches.

However, as I wrote in my previous column, you have to protect yourself when you deal with ETFs. Make sure to place a so-called “limit order” on your ETF trade, setting a maximum price you’re willing to pay to buy or accept to sell. I generally set limits 3% to 5% above market when I’m buying or below market when I’m selling, the way I do when trading individual stocks.

Now that index ETFs have entered my consciousness, I compare their fees and costs with the equivalent index mutual funds, then pick whichever is cheaper. It works for me. It would likely work for you, too.

Read next: What’s the Difference Between an Index Fund, an ETF, and a Mutual Fund?

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