How to choose between mutual funds, ETFs when investing (for the tax efficient investor)

Pamela Yip for the Dallas Morning News/Olympian writes: Exchange-traded funds have taken the investment world by storm since becoming available in the U.S. in 1993.

“They’ve grown a tremendous amount,” said Ben Johnson, director of passive funds research at Morningstar.

Both ETFs and mutual funds bundle together investments — such as stocks, commodities, or bonds — to offer investors diversified portfolios.

“They’re like kissing cousins in many aspects, and too often people have segmented ETFs and mutual funds and made them sound like they’re completely different investment vehicles and approaches,” said Joel Dickson, senior ETF strategist at Vanguard. “What underlies both is a diversified, commingled, generally low-cost professionally managed investment portfolio.”

But ETFs and mutual funds are very different in other aspects that savvy investors should keep in mind. 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.

Most ETFs track a particular index and typically have lower operating expenses than actively invested mutual funds.

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, managing director of ETF research at 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. “Actively managed funds tend to be the least tax-efficient, except for those that are managed for tax-efficiency.” The reason ETFs are tax-efficient is that most track indexes, meaning the fund manager buys stocks and aims to hold them over time.

Buy mutual funds if:

 • You’re making small, regular investments.

 • You want a fund that potentially could beat the market.

Of course, it doesn’t have to be an either-or situation for you. You can have both ETFs and mutual funds as investments.