Find out which investment wins: Here’s our mutual fund vs ETF comparison.

When considering a mutual fund vs ETF for your portfolio, it’s important to have a strong understanding of each.

Mutual funds are diversified portfolios of equities and investments in which small investors can take part. They are actively managed investments, with individual shares called units.

Exchange-traded funds hold baskets of stocks that represent stock indexes. ETFs are set up to mirror the performance of a stock-market index. They offer much lower fees than index mutual funds. They can save you a lot of money and boost your returns over time.

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Mutual fund vs ETF: What you should know before buying ETFs

Investors use ETFs in a variety of ways. To make the best use of ETFs, you should know both the advantages they offer, and some potential drawbacks.

Diversification is one of the most attractive features of ETFs. With an ETF, an investor is accessing all the stocks in an index.

Typically ETFs are more tax-friendly and offer significantly lower fees than mutual funds. However, MERs (Management Expense Ratios) for some newer, themed ETFs can be considerably higher than those for ETFs that simply track an established index.

Here are several other important considerations.

Before buying ETFs you should know:

1. ETFs can be volatile, even with the diversification they offer.
2. Look at how broad the base of the fund is, so you can determine its volatility. The broader the ETF, the less volatility it is likely to have.
3. The economic stability of countries when investing in international ETFs.
4. The liquidity of ETFs you invest in.
5. ETFs are subject to capital gains tax just like individual stocks if held outside a registered retirement account—and dividends distributed by foreign ETFs are not covered by the Canadian dividend tax credit.
6. That you can run up commissions with frequent trading.

The best ETFs have lower MERs

The MERs (Management Expense Ratios) are generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing their portfolios, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

Mutual fund vs ETF: 6 types of mutual funds to avoid

1. Beware of buying vaguely described mutual funds
2. Avoid buying mutual funds that trade in derivatives
3. Avoid mutual fund managers who trade heavily
4. Avoid buying mutual funds with a lot of dead weight
5. Avoid buying mutual funds with anonymous managers
6. Get out of buying “theme” mutual funds

Mutual fund vs ETF comparison: Why we prefer ETFs over buying mutual funds

1. ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in a mutual fund with a similar focus. With fees as low as 0.06% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher on their fund. ETFs can save you a lot of money and boost your return if you are investing over time.
2. ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.
3. Low turnover. Shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

One interesting note about buying mutual funds comes from the Dalbar organization.

This U.S. research firm’s studies of top-performing mutual funds show most of their investors who jump in at the top will lose money or make negligible returns. That’s because most investors in a top-performing fund only buy into the fund after it has already made big gains. Investors also tend to sell former top-performing funds only after a major slump in the value of their holdings. When you chase investment performance, it’s all too easy to buy at the top and sell at the bottom.

What do you think about the mutual fund vs ETF comparison? Which do you prefer? Share your thoughts with us in the comments.

This article was originally published in 2017 and is regularly updated.