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What's better for tracking an index: a mutual fund or an ETF?

June 15, 2011: 5:00 AM ET

Vanguard offers two funds that track the same index, but one is a mutual fund and the other is an ETF. What are the pros and cons of choosing one over the other?  Does it make a difference if the investor's intent is long-term (say, holding the fund in an IRA)? — Name withheld

Ultimately, choosing between the ETF and a mutual fund offered by Vanguard will come down to two things: the way in which you plan to invest (do you just want to slap down a chunk of money once a year and or will you be actively investing throughout the year?) and how much control you want over your investments.

"For a long-term investor, the key difference between the conventional fund and the ETF is the flexibility," says Don Bennyhoff, senior investment analyst at Vanguard's investment strategy group.

ETFs are often touted for their flexibility. Unlike mutual funds, which price once a day at the close of the markets, investors in ETFs can buy and sell investments throughout the trading day. You can set limits on prices and even short stocks if you want. That may not seem like much of a perk now, especially since this particular investment tracks an index fund you may just want to buy and hold. But it could come in handy come retirement when you're ready to liquidate your account, says Manisha Thakor, a personal finance expert and founder of the Women's Financial Literacy Initiative.

The downside of this flexibility: If you flex too much, it will cost you. While ETFs are slightly cheaper than conventional index funds (they are also touted for carrying lower expense ratios), they do carry transaction costs that can add up. Each time you conduct a transaction, you pay what's called the "bid-ask spread." This spread can be pretty small or pretty big based on the liquidity of the shares.

If you're going to be buying shares every week or every month, or if you're just buying a few shares here and there, then those transaction costs are going to make the ETF a pretty expensive proposition, says Mariana Bush, head of closed-end fund and ETF research at Wells Fargo Advisors.

However, if you're more the buy-and-hold type and plan on investing once a year, then the low expense ratio and other benefits of the ETF make it an attractive choice, she says.

— Nicole Ridgway

Posted in: Investing, Uncategorized
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