One reason is that ETFs tend to have lower expense ratios versus mutual funds, because ETFs are not actively managed. Most ETFs simply attempt to replicate a pre-existing index, or as I explain about smart beta funds in the next article, will place their own weights on the components that make up an index, rather than employ analysts and portfolio managers in an attempt to beat the market. Index ETFs also oftentimes have lower expense ratios than their counterpart index mutual funds. For example, in March 2015, the Vanguard S&P 500 index fund (Ticker: VFINX) had an expense ratio of 0.16%, which is about the lowest mutual fund expense ratios you will ever find. Yet the SPDR 500 exchange traded fund (Ticker: SPY) that tracks the very same S&P 500 index, had an expense ratio of 0.09%. Why does that matter? Say you want to invest $250,000 in the S&P 500 Index for 20 years. Buying SPY instead of VFINX would save you $250,000 x .0007 = $175 per year that you could keep invested in the S&P 500. Assuming an annual return of 10%, and ignoring taxes, that $175 per year would give you an extra $10,023 in 20 years. Not a huge difference in the grand scheme of things, but not bad for about two minutes of work.

Another reason is that ETFs are more flexible, especially for traders. You can buy and sell them on an exchange at a known price, whereas mutual fund prices aren’t determined until after the market closes each day, and you can sell ETFs short, or purchase and sell them with limit orders. Some ETFs also have liquid options markets. Yet another reason is that ETFs are more tax efficient. Each year, mutual funds pay capital gains taxes, which can lead to an increased tax bill for you if you hold them in a taxable account. ETFs, on the other hand, do something called paying their distributions in kind, which typically does not lead to an increase in your taxes due.

But mutual funds have a few advantages of their own. One is many have a low investment requirement, so they are more suited for people who prefer to invest a little money at a time. ETFs charge a fixed commission for each amount you purchase, and those commissions can be really high on a percentage basis if you are investing small sums at a time. For example, say you contribute $50 every two weeks to your retirement, and that you can either buy a mutual fund with a 5% load (commission), or an ETF that carries an $8 commission no matter how many shares you buy. The commission on the mutual fund is 5%, but the de facto commission on the ETF is $8/$50 = 16%.  The same logic applies to portfolio rebalancing. ETFs will always charge you a commission to buy and sell shares, but mutual funds may not, depending on the load structure of the fund.

Mutual funds will also give you many more alternatives if you want to try to beat the market through more actively managed funds. Finally, most mutual funds will allow you to reinvest dividends and capital gains automatically, which as I explained earlier can really contribute to growth over time. Not all ETFs allow this.

Overall, I tend to prefer ETFs for index investing, especially for taxable accounts, and provided that you can reinvest their dividends/distributions, and do so without incurring commissions. But if you are looking to invest only a little as you go, then mutual funds may be the better option for you. Mutual funds could also be more suitable if you are looking to beat the market, although as I explain in the next article, “smart beta” ETFs may allow you to do this as well.

The following chart summarizes the main differences between the two: