Mutual Funds or ETFs? / These two types of funds have key differences.

Manisha Thakor | for MorningStar writes: A lot of people use the terms mutual fund and exchange-traded fund interchangeably. While similar in many respects, these two investment vehicles have key differences. Mutual funds, particular those low costs ones following indexes, tend to be ideally suited for long-term, “evidenced-based”, asset allocation oriented investors. ETFs, on the other hand, are able to be traded intra-day, tend to be cheaper than active mutual funds and have the potential to be more tax-efficient if utilized in an active management context.

Simply put, mutual funds and exchange-traded funds are both mixes of various investments such as stocks and bonds that professional investors create. Think of them as financial smoothies. Rather than buy the individual fruits and vegetables, you purchase a serving of a smoothie that someone else prepares.

That serving is called a share of a mutual fund or an ETF. The key benefits of these financial smoothies are diversification and professional oversight.

The main difference is that mutual funds get priced at the end of the day, making them more appealing to long-term investors. These aren’t for hyperactive traders that want to take advantage of daily price swings. You can easily purchase specific dollar amounts at regular intervals, often with minimal transaction costs. The tax consequences of owning mutual funds are spread across all shareholders. But if you focus on the subset of mutual funds known as passive funds, these costs are minimal. Passive funds track indexes, so their managers seldom have to run up costs buying and selling positions.

However, if you plan to actively trade in and out of positions, based on the latest news, or want to set a pre-determined price at which you buy or sell a security, ETFs make more sense. ETFs trade all day long, just like individual stocks. You can place orders to buy or sell at a specific price. A downside: If you make frequent short-term trades like that, tax consequences are greater than holding for long periods.

So which is better? The answer really depends on your investment strategy. My personal opinion is that the vast majority of investors are best off with a diversified, low cost, long-term investment approach consisting of investments in index (a.k.a., passively) oriented vehicles. If you concur with this concept (and not everyone does), mutual funds often make the most sense. Index funds are set to track a benchmark such as a stock index. Passive management means that the investors aren’t paying for excessive trading fees and sky-high managers’ salaries and bonuses.

ETFs are hot right now because many believe they have lower fees than mutual funds. While ETFs do charge lower fees than the average actively managed mutual funds, passively managed mutual funds charge low fees on par with ETFs.

What ETFs do provide over mutual funds is greater control over the tax impacts of the investment. Taxes are not assessed on ETF investments until you sell your shares. This includes any taxes on sales of assets within the fund. Unlike mutual funds, you can delay the entire tax impact until you sell your shares. One common strategy is to sell the shares at a profit when other investments suffer losses, allowing the losses to offset the gains. This lessens the tax impact because your total capital gains are lower.

Your personal tastes and preferences determine which combination is right for you. Understanding the basic differences is a solid first step in creating your own investment recipe.