NEW YORK (TheStreet) - The stock market is enough of a random walk so most small investors should not try to pick stocks. So they are left with propositions from mutual funds, ETFs, and wealth managers.

I discard wealth managers because I like, as a minimum, three-year track records, and most do not have them. That leaves mutual funds and ETFs.

We have all heard the arguments. ETFs are better than mutual funds because of lower fees; because they can be bought and sold during market hours just like stocks; and because mutual funds underperform the indices that represent them, so why not buy the indices?

If you read much on finance, you might think ETFs had become the investment vehicle of choice. But how pervasive have ETFs actually become? And are they better than mutual funds?

Data on ETFs and Mutual Funds

Consider first U.S. household holdings of financial assets. Table 1 shows that the largest holding is pension funds. A large portion of pension funds is invested in mutual funds. The corporate equity category includes individual stock holdings and ETFs. The

Fed

does not give a separate breakout for household holdings of ETFs. But overall, it reports ETF holdings of $875 billion.

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Table 2 provides data on both mutual funds and ETFs for the end of October, 2010 as well as the change since December, 2009. Mutual fund holdings still dwarf ETFs, but ETFs are growing more rapidly.

Even so, the absolute growth of mutual funds over the last 10 months exceeded the growth of ETFs. The mutual fund data also reflect investors liquidating close money substitutes at the end of the bank panic to get back into equities.

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Critique: ETFs vs Mutual Funds

There is no question ETFs are easier to trade and their fees are lower. On mutual funds underperforming the market, I got out a 2007 Morningstar Principia CD and made a couple of searches for funds categorized by Morningstar as domestic growth (large, mid, and small cap). How did they do relative to the

S&P 500

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for the three-year period ending June 30, 2007? The results are presented in Table 3.

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OK. Seventy percent of mutual funds underperform the market average. But note there were 800+ no loads that did better than the market average.

Consider a few points on ETFs.

  • Jeff Middleswart, the manager of The Vice Fund (VICEX) - Get USA Mutuals Vitium Global Investor Reportpointed out to me : nearly all stock indices (foreign and domestic) are heavily weighted toward banks and real estate. These are the areas of the market that normally trigger problems that cause market meltdowns. My recommendation: Never buy an ETF without looking carefully at what equities it includes.
  • ETF excesses: The editor of a major financial Web site said they are being overwhelmed by new ETF offerings, like the garden catalogue season is coming in the U.S. How about an ETF that includes a publicly traded wheel barrow company in Hungary with a Chinese company that makes garden tools? He said a large portion of new ETFs "never see the light of day" -- someone takes a flier and if there are not enough buyers; it is not launched.

I hold both ETFs and mutual funds. If one outperforms the other for an investment area that interests me, I buy it.

What am I saying? In the new enthusiasm over ETFs, don't forget the 30% of the mutual funds that outperform the market.

My complete portfolio can be seen at

http://www.morssglobalfinance.com/hedging-long-positions-in-emerging-markets/

.

Note: I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell a security.

Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.