Last week, we looked at some of the distinctions between mutual funds and exchange-traded funds. Specifically, we discussed how each is acquired and disposed of by investors, and highlighted similarities and differences in their underlying structure.

Today, let's consider why you might favor one vehicle over the other.

some text

In essence, all mutual funds and ETFs serve the same broad purpose: to aggregate cash from individual investors and deploy those proceeds in a basket of securities that meets a specific stated objective. So the first consideration is the objective you seek to achieve.

If you desire an active strategy whereby a manager or team of managers engages in strategic trades intended to outperform some market benchmark or to employ a particular strategy, then mutual funds are probably for you. There are nearly 8,000 different objectives within the mutual fund universe, encompassing virtually any investment approach you can imagine (and some you couldn't imagine). Many investors prefer to buy into funds run by talented managers, expecting them to produce superior performance relative to the broad market.

In selecting this approach, be prepared to pay up. Fees and expenses in actively managed funds can easily run from 0.80 percent to 2 percent or more (in addition to sales loads). But for investors seeking the expertise and judgement of professionals employing specific investment philosophies rather than replicating an index, mutual funds offer the widest array of choices. Many of these actively managed funds are available with no loads on a number of discount platforms.

On the other hand, if you prefer riding along with the broad markets incurring minimal total costs, ETFs are generally superior. The majority of ETF offerings are not actively managed, but seek instead to mimic the results of major indices like the S&P 500, or to mirror the behavior of specific sectors, industries and geographies. Certainly there are traditional mutual funds with the same objectives, but ETFs usually undercut them on expenses, if only by a small amount.

Many discount brokers now offer a full slate of major index ETFs with annual expenses of less than 0.10 percent, many with no commission charges.

It should be noted that a growing number of ETFs employ more active strategies, including betting against an asset class (shorting) and employing leverage to magnify the amplitude of gains and losses. These should be used with caution and only by experienced investors with a high tolerance for risk.

Another important consideration is taxes. If your portfolio resides within a tax-deferred account like a 401(k) or IRA, the tax impact of mutual funds is moot. However, in taxable accounts, the choice carries significant implications.

In general, the cost basis for an ETF is the purchase price plus any commissions. Hence investors dictate the timing of capital gains or losses in deciding when to sell, regardless of the actions of any other investors.

Conversely, when you buy a mutual fund, you essentially inherit the existing cost basis of underlying basket of securities. Capital gains and losses generated within the fund are reported annually to the fund's investors. Under this scenario, an investor buying fund shares late in the year could be subject to capital gains taxes without receiving the benefit of the appreciation. In some cases, holders may experience losses in the fund's shares but still receive a tax bill for transactions prior to their actual investment.

Both ETFs and mutual funds are useful and effective tools for achieving diversification and implementing asset allocation decisions. Each has its own particular advantages, and investors would be well served by discussing the pros and cons with an adviser before pulling the trigger.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett and Co. in Chattanoooga.