So, how do you tell whether an ETF or a conventional mutual fund is best for you? Here are some things to consider:
What You Want to Invest In
ETF providers have increasingly aimed to provide funds for investors looking to invest in a narrow market segment. The ETF universe is flush with funds that focus on a single market sector, industry, or geographic region. Say you favor indexing and want to own a specific corner of the market such as biotech. There may not be many index mutual funds that track those sectors--but there are ETFs that do. Also, there are many more ETFs than funds that track single foreign countries. Exchange-traded funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks (plus, it's more cost-efficient in terms of brokerage commissions).
However, it's also worth noting that narrowly focused funds--whether ETFs or conventional offerings--can be too hot to handle for many investors. That's because investors are often inclined to buy and sell narrowly focused funds at inopportune times, as evidenced by Morningstar Investor Return statistics.
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 ETFs with Morningstar's Valuation Quickrank tool.
ETFs are also structured to shield investors from capital gains better than conventional funds. Currently, nearly all ETFs are index funds, so they typically trade less than most actively managed funds and should generate fewer taxable capital gains. Also, because most investors buy and sell ETF shares with other investors on an exchange, the ETF manager doesn't have to worry about selling holdings--thereby triggering capital gains--to meet investor redemptions. Moreover, because the big institutions can make share redemptions "in-kind" (rather than redeem shares for cash, the ETF gives the institution a basket of stocks equal in value to the share redemption), ETFs can unload their lowest-cost-basis stocks in the portfolio, thereby reducing their capital gains exposure.
Because ETFs don't have to manage hundreds of customer accounts or staff call centers, they have lower overhead charges that translate into lower expense ratios. However, you'll will pay brokerage commissions to buy and sell ETF shares, and the costs of rapid--or even occasional--trading can more than offset the initial advantage of an ETF's lower expense ratio. For those reasons, an ETF will be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For others, an exchange-traded fund may not have a big cost advantage over a plain-vanilla, low-cost index fund. Morningstar's Cost Analyzer tool can help you compare the fees.
ETFs may also be a suitable option for areas of the market where traditional mutual fund offerings are scarce, expensive, or run by managers with little experience. As in choosing traditional index mutual funds, it's best to evaluate an ETF's fees and the usefulness of the benchmark it tracks before buying in.