Are You Choosing the Right Fund for Your Portfolio?

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With a market of over $30 trillion, mutual funds are some of the most popular investments. But the $3 trillion ETF (Exchange Traded Fund) market is catching up quickly. So, what are ETFs? How do they differ from mutual funds? And are they right for you? Here's what you need to know:

Mutual Funds 101

When you invest in an individual stock, the success of your investment is completely dependent upon the success of that one company. But when you invest in a mutual fund, your money is diversified. It's pooled with many other investors' money and then invested in many companies, based on the design of the fund or the decisions of the fund manager.

It's the same with bonds and bond funds, or real estate and real estate funds.

Think of an exchange-traded fund as a close cousin of a mutual fund. It, too, manages a pool of money from many investors, spreading it among many investments. But there are some very important differences between ETFs and mutual funds.

ETFs Are Priced Throughout the Day

When you enter an order to purchase a mutual fund, the order will fill at the end of the day, after the value of all of its underlying assets are tallied.

ETFs, on the other hand, can be bought and sold throughout the day like stocks. When you enter an order to purchase an ETF, your order will typically be filled very soon after entering the order at a price very close to the price you saw when you placed the order.

That's one of the main reasons why ETFs were created. On October 19, 1987, a day now known as "Black Monday," the U.S. stock market fell by nearly 23%. Mutual fund investors who wanted to sell their shares couldn't until all the damage had been done. Three years later, the first ETF was launched, giving investors all of the diversifying benefits of a mutual fund but the flexibility to buy or sell throughout the trading day.

ETFs Have Lower Expenses

Exchange-traded funds tend to have lower operating expenses than mutual funds, and that lower cost structure is passed along to investors in the form of lower expense ratios. For example, Vanguard's S&P 500 index mutual fund (ticker symbol VFINX) has an expense ratio of .16%. If you invest $1,000 in the fund, $1.60 will go toward fund expenses. That's already very low. However, if you invest in Vanguard's S&P 500 exchange-traded fund (ticker symbol VOO), you'll pay an even lower expense ratio of .05% — or 50 cents per $1,000 invested.

ETFs Have Lower Minimums

Many mutual funds have minimum initial investment amount requirements. Common amounts range from $250 to $3,000, but some funds require as much as $10,000.

With ETFs, the minimum investment amount required is the cost of one share. If you wanted to invest in Vanguard's VFINX mutual fund, you'd need to come up with at least $3,000 for your initial investment. However, getting started with what, in essence, is the ETF version of the same fund, VOO, would cost only about $190 — the price of one share when this article was written.

Which Is Better?

There are three main factors that can help you decide whether to go with a mutual fund or an exchange-traded fund.

Availability

You may not have a choice. Some 401K plans don't yet include ETFs in the investment options they make available to participants. If that's true with your workplace plan, you'll have to go with one or more of the available mutual funds.

Strategy

While the ETF universe is growing rapidly, there are still many more mutual funds. So, it could be that the investment strategy you're following calls for the use of a particular mutual fund and there are no suitable ETF substitutes.

Cost

If you're following an investment strategy that calls for the use of a particular fund that's available as a mutual fund or an ETF, check on each one's expense ratio. It's very likely that the ETF will cost less, making it the better choice.

One Last Consideration

Some critics say ETFs can get investors in trouble by encouraging more trading. They argue that because the funds can be bought and sold throughout the day, they'll tempt otherwise conservative investors to take undue risk and turn them into roll-the-dice day-traders.

But that's like arguing that because some people get into car accidents, no one should be allowed to drive. If you follow the rules of the road for wise investing — if you're a long-term investor, not a short-term trader — ETFs can be a very efficient, cost-effective investment vehicle.

So, which is it for you? Mutual fund or ETF?