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The Short Answer

When Mutual Funds Beat ETFs

Brokerage fees, lack of active offerings can tip the scales.

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Question: What are the drawbacks/disadvantages of owning ETFs over conventional mutual funds?

Answer: For some investors, exchange-traded funds have become the investment vehicle of choice. The explosive growth of ETFs over the past decade--U.S. ETFs added $241 billion in net assets in 2014 alone, lifting their total net assets to $2 trillion--can largely be attributed to advantages that ETFs offer as compared with traditional open-end mutual funds.

Perhaps the most significant of these advantages is price. ETFs have been given a boost by investors' appetite for index-based investments, which tend to be less expensive to operate than funds that use active strategies. Most ETFs track indexes, with some offering exposure to indexes that are unavailable in mutual fund form.

ETFs also are cheaper to operate because of structural differences and lower administrative costs--for example, ETFs don't have to pay customer-service reps to answer investor phone calls or emails while mutual funds do. Because of these operational cost differences, ETFs often are able to charge less than mutual funds--even those that track the same index. And in this era of cost-conscious investing, lower prices tend to draw investor dollars.

Another key difference is that, unlike mutual funds, ETFs trade while the market is open, giving investors who are worried about having to wait until the market closes to sell shares a greater sense of control. Equity ETFs also can be more tax-efficient than mutual funds in that they may avoid making capital gains distributions. (For more on why, and also why some types of ETFs are more adept at this than others, read this article.)

ETFs aren't just gaining popularity with individual investors, either. Many financial advisors now use them as a way to lower costs and increase tax efficiency for their clients. (Christine Benz, Morningstar's director of personal finance, writes here about "8 Questions to Ask Before You Follow Your Advisor Into ETFs.")

But for all their advantages, ETFs are not without flaws, and there are times when using traditional mutual funds may be preferable. Here are a few.

If you're dollar-cost averaging: Unlike mutual fund shares, which typically are bought and sold through a fund company, ETF shares must be purchased from a brokerage. And, as with stocks, buying or selling ETF shares may mean paying a brokerage fee each time. That's a fee on top of the expense ratio charged by the ETF.

These days, with brokerage commissions of $10 or less commonplace, this additional cost may not outweigh the cost advantage of using an ETF over a comparable mutual fund when investing a lump sum. But what if you plan to invest in chunks rather than all at once? In particular, what if you plan to dollar-cost average into an ETF, making monthly share purchases over the course of a year? Each time you make that monthly purchase, you may be required to pay a brokerage fee, which can quickly eat away at the ETF's expense-ratio advantage, depending on the amount of money being invested.

These days, this is less of an issue than it was in the past as some brokerages--including Charles Schwab, TD Ameritrade, Fidelity, and Vanguard--offer commission-free trades for some ETFs. Of course, this limits the investor to a list of ETFs run by the brokerage company or its partners, but it does provide a low-cost way to dollar-cost average into ETFs without worrying about brokerage fees eating away at performance.

If you prefer active management: True, there are some actively managed ETFs, but the vast majority are index-based. One reason: Actively managed ETFs are required to disclose their holdings on a daily basis, and most active managers are reluctant to do so for fear that traders will attempt to front-run, or trade early, on their strategies. Actively managed mutual funds, by contrast, only have to disclose their holdings quarterly. (Morningstar columnist Scott Cooley writes here about how a new fund type, the exchange-traded managed fund, is designed to circumvent the ETF daily disclosure rules.)

If you're more comfortable with stock-picking than indexing, chances are you'll need to look to traditional mutual funds to build the bulk of your portfolio.

If not being able to trade during market hours is a good thing: The perceived advantage of being able to trade ETFs while the market is open could be a detriment to some investors. If you're the type who gets jittery every time you see the indexes take a plunge, investing in mutual funds might actually convey a behavioral advantage for you, removing the temptation to act on impulse and forcing you to wait until the market closes to move your assets around.

If you find that mutual funds are actually cheaper: While conventional wisdom says that ETFs are usually cheaper than comparable mutual funds, that isn't always true. A case in point: institutional share classes of some index funds found in employers' 401(k) plans. For example, the Vanguard S&P 500 ETF (VOO) charges 5 basis points (0.05%) while Vanguard Institutional Index (VINIX)--a traditional mutual fund available to investors through 401(k) plans that can meet its $5 million minimum--costs just 4 basis points (0.04%). (The two are technically share classes of the same Vanguard S&P 500 fund.) But even outside of institutional share classes, many fund companies offer index mutual funds at prices that are in the same ballpark as ETFs that track the same index. For those investing money over time rather than in a lump sum, this cost difference may be small enough to merit using a mutual fund if it helps save on commissions.

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.