Like all sectors, the financial service industry has evolved over time. Many of the new products introduced throughout recent years have not served investors well, but from time to time the industry gets it right. Exchange Traded Funds, or ETFs, are one such innovation that has largely benefited the investing public. Let’s compare these with their older cousin, the mutual fund, and assess when and how ETFs can enhance your investment program.

For small accounts of passive investors, a low-cost mutual fund can be an excellent means for wealth creation. The same holds true for the investor who is adding small amounts to his account at regular intervals. Most mutual funds will let you purchase additional shares in small increments without sales charges; thus, for those putting money away monthly from their paycheck, for example, mutual funds can be a good investment vehicle.

Mutual funds, however, have certain inherent disadvantages compared to ETFs and individual stocks. The first is that of liquidity (frequency of trading). While for investors with very long time horizons intra-day trading is not essential, for traders looking to take advantage of near-term fluctuations, the once-a-day pricing of mutual funds is certainly a drawback. By contrast, ETFs trade throughout the market day. Even if you are not concerned about trading a fund intraday, you could be discouraged to have entered your mutual fund sell order in the morning when the market was up, only to discover when you confirm the sale order the next day that your price was much lower than ex­pected because the broad market sold off late in the day.

Furthermore, the published portfolio holdings of mutual funds are stale, with position updates quarterly at best. The fund manager could have made material changes to the portfolio between the time the holdings were last updated and the time you bought into the fund, so you cannot be certain what you are buying at any given time. ETFs, on the other hand, have essentially fixed portfolios, the contents of which are available for review and analysis at any point. With ETFs, you know more and you have more control over what you are buying.

Another advantage of ETFs is that they can be sold short; you can bet that they will decline in value. This adds additional flexibil­ity in terms of risk control and portfolio management. ETFs tend to be more cost effective whereas actively managed mutual funds can have ex­pense ratios of 1.2 percentor more, versus an expense ratio of around 0.3 percent for the typical ETF. Trading costs are another important consideration. Commissions can potentially add 0.50% or more to mutual funds expenses — costs buried in the fine print of the fund prospectus. Taxes are another reason to consider ETFs over mutual funds — the latter often paying out large capital gains even to those who did not participate in the earnings themselves. Getting the tax status on mutual fund holdings is often challenging, which can lead to nasty surprises and large tax bills for those who buy into a given fund just prior to distribution.ETFs, on the other hand, do not typically have any embedded taxable gains.

An additional subtle, but important, differen­ce between ETFs and mutual funds is the impact of capital flows. A mutual fund that is going through a hot streak will often see very large capital inflows after publishing impressive results. As the typical retail investor often chases yesterday’s outsized returns, the fund will invariably experience large capital inflows just before—or just as—the securities in which the manager is investing are peaking in value. The manager feels compelled to put this new money to work almost regardless of security valuation. Think of all the large-cap growth managers who received literally billions in their cof­fers in the late 1990s and who were essentially forced to buy stocks they often recognized were overvalued. All of this exacerbates the trend in the near term, making the music last a little longer before the party ultimately is over.

Conversely, if a manager has a cold spell, or more typically gets into a sector that she feels has good long-term prospects but is subject to short-term capital depreciation, the resulting underperformance will often cause assets to flee. It is not uncommon for mutual funds to go from many billions of dollars to only a couple of billion in assets. All those investors clamoring for their money back are expecting a check in the mail, and that triggers massive selling by the mutual fund manager, which in turn sends portfolio holding prices even lower in the near term. Thus, there is quintessentially a “prisoner’s dilemma” phenomenon with mutual funds in that the actions of one participant can have a material impact on another investor in the same pool. The same reality does not apply to ETFs, as they have a mechanism in place to facilitate redemptions without having to sell the underlying shares en masse.

The final important factor when considering ETFs versus their mutual fund brethren is the ability to buy/sell options against the underlying securities. Simply put, there are no options on mutual funds. There is no way to directly hedge or take advantage of your mutual fund’s holdings by generating income through call sales, for example. By contrast, many hundreds of ETFs have options that trade against them.

Bottom line, for sophisticated investors ETFs and individual stocks can be superior to mutual funds when it comes to structuring and hedging a portfolio.