How to Choose Between an ETF and a Mutual Fund

The breakeven of an ETF over an open-end mutual fund depends on a number of variables, including:

Expense ratios of the ETF and the comparable no-load fund. A wider differential between the expense ratios will result in a briefer breakeven span.

Brokerage commissions. The higher the commissions to buy and sell the ETF, the longer the breakeven. At Vanguard, commissions range from $8 per trade for to as much as $45 per trade plus 5 cents per share. The example above was for an online investor with less than $1 million in Vanguard investments.

The amount of the purchase. If a fixed-dollar commission is spread out over a larger investment, the percentage gap in cost between the ETF and the comparable no-load fund is narrowed.

The return on the investment. The higher the rate of return, the shorter the breakeven period.

The bid/ask spread of the ETF. Larger spreads translate into lengthier breakevens. In the above example, the bid/ask spread on the Vanguard ETF, over a period of time, varied between 1 cent and 4 cents, with 3 cents the most common spread.

Front-end sales charges and/or redemption fees on funds. Unless very small purchases are anticipated, the sales charges on front-end load funds and those with redemption fees render them uneconomical when compared with ETFs.

If you don't care to go through the calculations comparing the costs of no-load fund with a comparable ETF, a good rule of thumb is to go with the ETF if you anticipate holding the investment, untouched, for at least five years.

Ironically, however, ETFs can be ideal vehicles for "hedging" and active trading. Many are extremely liquid and maintain bid/ask spreads of only a penny a share. For example, $40 billion to $50 billion in shares of the SPDR S&P 500 ETF (SPY Quote) consistently change hands on a typical trading day.

So, generally, ETFs might best be described as "barbell investment" -- very practical for short-term trading as well as for buy-and-hold programs lasting half a decade or more.

Of course, an ETF should be considered if it offers unique coverage of an area that an investor feels is essential. Examples might be a "triple-inverse" ETF that hedges a specific market segment of one with a narrow focus or unconventional portfolio weighting technique that an investor feels has a particularly bright future.

While commissions, total expense ratios and sizes of transactions are the primary considerations in decisions about open-end mutual funds and ETFs, a number of other factors also impact the relative appropriateness of one or the other in various situations. A nearby table summarizes the comparative attributes of each.