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Decision: Mutual funds vs. exchange traded funds

- Alan Lavine and Gail Liberman

The battle between exchange traded funds and mutual funds intensifies, and I'll let you in on a few of my own conclusions about these two investments.Again, with exchange traded funds, like iShares, SPDRs or QQQs, you buy shares through a broker in a selection of stocks or bonds. You can trade them on the stock exchange throughout the day at the market price. With mutual funds, you're buying shares in the pooled fund. Its manager or managers do the investing. You can skip a brokerage commission if you buy directly from a mutual fund company, and you get a mutual fund's price only once--at the end of the day.

We will probably get tons of hate mail from this, but here's our take on both categories of investments:

  • Whether you invest in exchange traded funds or mutual funds may be less important than the specific exchange traded fund or mutual fund you choose. There are good investments and lousy investments in both categories. Plus, either way, you can lose if your selection is too risky, you're not well-diversified or you're paying to much in fees and taxes.

  • Whether you select exchange traded funds or mutual funds should depend upon what you are seeking specifically from your investment. For example, if you seek monthly income, you could have a tougher time finding an appropriate bond exchange traded fund than a bond mutual fund. By contrast, other exchange traded funds lack mutual fund counterparts, says Timothy Meyer, exchange traded fund manager for Rydex Investments. Examples: StreetTracks Gold Shares (GLD) and Barclay's COMEX Gold (IAU), which let you invest directly in gold bullion. Mutual funds, on the other hand, only buy gold-related stocks.

  • Regardless of whether you opt for exchange traded funds or mutual funds, the adviser you select to manage your money could be key. Add his or her fees on top of commissions you pay for exchange traded funds or loads you pay on mutual funds, and you had better be getting extraordinary performance!Morningstar Inc., Chicago, may have fired the latest salvo in the battle between these two types of investments.

Despite all the hype about exchange traded funds, mutual funds have the most assets, notes Dan Culloton, Morningstar senior analyst in a Fund Spy column on Morningstar.com. At the end of August, there were $8.5 trillion in mutual funds compared with $251.5 billion in exchange traded funds.

In fact, Culloton says, 60 traditional no-load mutual funds have expense ratios--or fees as a percentage of fund assets--as low or lower than the .30 percent median exchange traded fund expense ratio.

Among the great mutual fund deals both expense-wise and tax-wise:

  • Vanguard's Group's of tax-managed funds.

  • Fidelity Spartan 500

  • Fidelity Spartan U.S. Equity

  • Fidelity Spartan International

  • Bridgeway Blue-Chip 35 Index

"Once you factor in the brokerage commissions you have to pay to trade (exchange traded funds), these funds are often as cheap or cheaper than (exchange traded funds)," Colloton says.

Claims of the tax-efficiency of exchange traded funds also can be matched by certain mutual funds. Vanguard 500's (VFINX) tax cost ratios for the trailing one-year, three-year and five-year periods ending in September, are lower than those of both exchange traded fund competitors--SPDR (SPY) and iShares S&P 500 index, Colloton says.

A couple of other differences between mutual funds and exchange traded funds to consider before deciding which way to go:Exchange traded funds provide the flexibility to sell short. You also can place limit orders and stop orders. Plus, you can purchase shares on margin. You can't always do this fancy footwork with mutual funds.

Besides paying commissions on exchange-traded funds, you need to watch the bid and ask spread when you buy an exchange traded fund. If the gap is large, you could be paying too much.

With an exchange traded fund that invests in the S&P 500, expect the gap to be only pennies, if that, Meyers says. With a less liquid fund, such as an international exchange traded fund, expect the gap to be wider.Invest in a mutual fund, and your fund manager shoulders this price burden. But chances are you'll be paying less because a fund manager buys stocks and bonds in bulk.

By the way, a comparison of the Vanguard Group's exchange traded funds and corresponding mutual funds shows very little difference in performance.Its energy VIPERs and REIT VIPERs exchange traded funds are the only ones of 23 that registered substantial different performance over mutual fund counterparts. The Vanguard's energy exchange traded fund's total return, since inception on Sept. 23, 2004, outperformed Vanguard's Energy Index Fund by 7.25 percentage points in total return. And the REIT Index Fund outperformed the REIT VIPER exchange traded fund by slightly more than one-half-of-one percent in total return since the VIPER's inception date.


Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).

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