Mutual Funds or Exchange-Traded Funds--What Type of Investor Are You?

Exchange-traded funds, like conventional mutual funds, hold a basket of securities. The primary difference is how the investor buys and sells his or her shares. Whereas investors in conventional mutual funds buy and sell their shares with the fund company, investors buying or selling ETF shares must trade on the exchange, much as they would do if they want to buy or sell shares of an individual stock. For that reason, individual investors must use a broker when they want to buy and sell ETF shares.

Some quick trading points

As the name suggests, exchange-traded funds are priced and traded on an exchange (AMEX, NYSE, or Nasdaq) throughout the day just like stocks. In contrast, traditional mutual funds' prices are set once a day (usually 4 p.m. Eastern) and investors must place their orders before that time in order to get that day's price, which is not determined until the end of the day. So in terms of buying or selling, the advantage with ETFs is that you can trade throughout the trading day and use different trading strategies such as limit orders, shorting or options. One potential disadvantage is that the market price may move away from the net asset value. Therefore, it can be useful to monitor an ETF's NAV before trading, particularly for less liquid ETFs.

Because most ETFs follow passive indexes, they appeal to two types of investors: those who prefer a passive index based approach and those who like to actively manage their own portfolio through such strategies as market timing.

You can build a whole portfolio

ETFs have democratized investing by opening exotic asset classes to the average investor. ETFs make it possible to build an entire asset allocation plan, including stocks, bonds, commodities and real estate all at a low cost. A passive investor can use these tools to buy, hold and rebalance. A more active investor may choose to time the market by moving in and out of ETFs based on their own research, without having to worry about the style drift or high fees of active managers. However, there are a number of low cost index mutual funds and some active mutual fund managers have shown an ability to beat an index.

Beware of using them the wrong way

It's also worth noting that narrowly focused funds—whether ETFs or conventional offerings—can be used inappropriately. That's because investors are often inclined to buy and sell narrowly focused funds at inopportune times or fail to evaluate the suitability of the investment in the context of their overall portfolio. That's not to say that focused ETFs can't be used intelligently, however. For example, ETFs may trade at discounts to the aggregate value of their holdings. If you're inclined to invest in more-focused ETFs, it makes sense to be a contrarian, not to chase what's been hot recently. You can find undervalued equity ETFs with the right tools.