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How to Choose Between an ETF and a Mutual Fund

Stocks in this article: VV VLACX SPY

Exchange-traded funds are fashionable. Most, as measured by total expense ratios, are cheap compared with traditional open-end mutual funds. ETFs offer potential tax benefits and can be bought and sold throughout the trading day whereas mutual fund transactions occur only at daily closing quotes.

So it would seem to be a no-brainer: Forget about mutual funds and buy and sell those trendy ETFs, right?

Not necessarily!

An ETF's advantage of a lower expense ratio than a comparable no-load mutual fund can evaporate because of brokerage commissions on trades. For the same reason, small transactions for portfolio rebalancing purposes or for regular "dollar cost averaging" programs are impractical with ETFs.

Even though ETFs are great investment vehicles in many respects, investors are advised to look closely at all costs -- especially brokerage commissions -- from every angle before opting for ETFs over mutual funds.

As a simplified example, suppose you're interested in a no-load mutual fund with an annual total expense ratio of 0.20%. But an ETF with an identical portfolio exists, priced at $42 per share, with a total expense ratio of only 0.07%.

If you intend to invest slightly more than $4,200 and have an online brokerage account that charges $20 for a typical trade, it would cost $4,240 to buy 100 shares of the ETF and then sell the holding some time in the future. If the price were to remain unchanged, the annual expenses would be $2.94. But the yearly expenses for $4,240 of the no-load mutual fund would amount to $8.48.

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