ETFs and Mutual Funds: A Sometimes Tricky Choice - dummies

ETFs and Mutual Funds: A Sometimes Tricky Choice

By Russell Wild

Say you have a choice between investing in an index mutual fund that charges 0.15 percent a year and an exchange-traded fund (ETF ) that tracks the same index and charges the same amount.

Or say you are trying to choose between an actively managed mutual fund and an ETF with the very same manager managing the very same kind of investment, with the same costs. What should you invest in?

If your money is in a taxable account, go with the ETF, provided you are investing at least a few thousand dollars and you plan to keep your money invested for at least several years.

If you’re investing less, and/or if you think you may need to tap the money anytime soon, you may be better off with the index mutual fund that won’t charge you commissions to buy and sell shares.

But say you have, oh, $5,000 to invest in your IRA. (All IRA money is taxed as income when you withdraw it in retirement, and therefore the tax efficiency of securities held within an IRA isn’t an issue.)

An ETF charges you a management fee of 0.15 percent a year, and a comparable index mutual fund charges 0.35, but buying and selling the ETF will cost you $7.95 at either end. Now what should you do?

The math isn’t difficult. The difference between 0.15 and 0.35 (0.20 percent) of $5,000 is $10. It will take you less than one year to recoup your trading fee of $7.95. If you factor in the cost of selling (another $7.95), it will take you 1.6 years to recoup your trading costs. At that point, the ETF will be your lower-cost tortoise, and the mutual fund your higher-cost hare.

In general, building an entire portfolio out of ETFs usually makes sense starting in the ballpark of $50,000. Anything less than that, and you are most likely better off with mutual funds or a mix of mutual funds and ETFs.

The exception would be, say, a portfolio of all Vanguard ETFs held at Vanguard, where there would be no trading fees. Or a portfolio of all Schwab ETFs held at Schwab, with the same deal. In these cases, the ETF portfolio may make sense for even the smallest of accounts.

Warning: If you have a trigger finger, and you are the kind of person who is likely to jump to trade every time there’s a blip in the market, you would be well advised to go with mutual funds (that don’t impose short-term redemption fees). You’re less likely to shoot yourself in the foot!