Mutual funds have historically been the leading means of investing in diversified products managed by professionals, but along came Exchange Traded Funds (ETFs), and the growth they’ve displayed has the mutual funds running scared. As of earlier this year, mutual fund investments outweighed ETF assets by nearly a 12-to-1 ratio ($12 Trillion to $1.1 Trillion). But, the gap between mutual funds and ETFs continues to shrink year after year as people seek investments which can provide similar returns at lower costs. The dollar comparison above is more than slightly misleading, because as of now, ETFs cannot be added to 401K Retirement Plan Portfolios. Still, ETF assets have grown over 1,000% between 1996 and the end of 2010, while the growth rate of Mutual Funds has remained flat over the same period.

For the small accounts of passive investors, a low-cost mutual fund can be an excellent vehicle for wealth creation over time. 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 very small increments without sales charges; thus, for those putting money away monthly from their paycheck, mutual funds can be a good means of investment. By definition, a set monthly investment achieves dollar-cost averaging—buying more shares when the market is down and fewer shares when the market is high—and maintaining this disciplined approach is important so that you can take advantage of the power of compounding.

Mutual funds, however, have certain inherent disadvantages over ETFs. The first is that of liquidity (frequency of trading). For investors with very long time horizons, intra-day trading is not essential, but for traders looking to take advantage of near-term fluctuations, the once-a-day pricing of mutual funds represents a negative. By contrast, ETFs trade throughout the market day. And even if you are not concerned about trading a fund throughout the day, you could be discouraged to have entered your mutual fund 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 portfolio holdings of mutual funds may have changed between the time you buy shares and the last published list of holdings so you cannot be certain what you are buying. ETFs, have essentially fixed portfolios, the contents of which are available for review and analysis at any point. You know more and you have more control over what you are buying.

Another advantage of ETFs is that they can be sold short. This adds additional flexibility in terms of risk control and portfolio management. ETFs tend to be more cost effective; actively managed mutual funds can have expense ratios of 1.2% or more, versus an expense ratio of around 0.3% for most ETFs. As mutual funds are traditionally actively managed, trading costs are another important consideration. Commissions can potentially add fifty basis points (0.50%) or more to the expenses associated with mutual funds. Taxes are another reason to choose ETFs over mutual funds, the latter often paying out large capital gains even to those who did not participate in the earnings themselves.

The final important factor when considering ETFs versus their mutual fund cousins is the ability to 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 are superior to mutual funds when it comes to structuring and hedging a portfolio.

(The information in this article is strictly for educational and illustrative purposes and is not an attempt to furnish personalized investment advice or services.)