index funds vs. mutual funds

There was a time when financial advisors all agreed on one thing: index funds vs. mutual funds. These days, however, you don't hear much about those anymore but you do hear a lot about exchange-traded funds or ETFs. While mutual funds continue to be popular, they cannot match the growth in popularity of ETFs. What's the difference between the two and why pick one over the other?

ETFs are like mutual funds in that they pool investment resources and usually spread them out over a variety of investments. ETFs, however, are designed to be traded like stocks. ETFs can be traded anytime the market is open and their prices will change during that time. Collective investment schemes are priced only at the end of the day and that is the only time they can be bought and sold. ETFs may be sold short and bought on margin; mutual funds cannot. ETFs have no management fees and usually have lower expenses too.

There are many types of ETFs that track many different markets. There are ETFs that track the Dow Industrials and the NASDAQ. Some track specific sectors, like technology. Others track the markets of foreign countries. And some even track commodities, like gold or oil. So when it comes to variety, ETFs can match mutual funds. It is safe to say that an ETF is usually a better choice over a mutual fund tracking the same market.

There are still some advantages to standard collective investments. If you wish to find a fund, which will outperform other similar ones, you have to find one whose fund manager can exercise some creative discretion when choosing it's underlying investments. Generally that option is limited to mutual funds. ETFs tend to automatically track certain market indices whose components are pre-specified.

Another reason you might pick a mutual fund over an ETF is when making long-term investments in a commodity. Since commodity-tracking ETFs must invest in futures contracts, there are a lot of expenses involved with turning those future contracts over. This can cause a ETF to underperform the index it is tracking. So for long-term investments, it might be better to find an asset which follows commodities surrounding business market, rather than and ETF which invests in the commodity itself.

Also, as an employee, your company's retirement plan might not allow for investing in ETFs. In that case, you'll need to select some mutual funds that meet your needs.