Carrie Schwab Pomerantz

Dear Carrie: Due to the popularity of exchange-traded funds, will traditional mutual funds become an investment vehicle of the past -- will they be the dinosaurs of the investing world? -- A Reader

Dear Reader: What a great question! There can be no denying that exchange-traded funds (ETFs) have shown explosive growth and have become an important part of the investment landscape. However, the fact is that traditional mutual funds outnumber ETFs about 10 to 1. According to the Investment Company Institute, at the end of 2009, there were 8,624 mutual funds available to American investors versus about 820 different ETFs (up from only 2 in 1995). So even though ETFs are clearly growing in number, in my view, mutual funds are nowhere near extinction.

I also love your question because it gives me the opportunity to highlight how ETFs differ from mutual funds -- and how both can help you achieve your investment goals.

ETFS & INDEX FUNDS: THE GOAL IS TO MATCH THE MARKET

As I'm sure you know, mutual funds come in two basic flavors. Actively managed funds seek to outperform the markets by superior stock selection or by looking for opportunities to exploit inefficiencies in the markets. On the other hand, index funds simply seek to match the performance of an unmanaged index.

For the most part, ETFs function like index mutual funds. Actively managed ETFs are starting to appear, but the vast majority aim to passively replicate a particular market or sector index. However, unlike a traditional mutual fund -- which you can only buy or sell at the end of the trading session -- you can trade an ETF throughout the day like a stock, and they also tend to be much more tax efficient. Some brokerage firms waive commissions for trading certain ETFs, but not all.

Both index mutual funds and ETFs are good instruments for low-cost, diversified exposure to the broad market or to specific segments. And given this, both can be great tools for implementing an asset allocation strategy. As I have said in this column before, your asset allocation -- the mixture of equities (U.S. and international), fixed income and cash -- is crucial to portfolio performance. Choosing between ETFs and index funds really depends on how frequently you trade and how important tax efficiency is to you, but either instrument can help you get the exposure you want.

ACTIVE FUNDS: THE GOAL IS TO BEAT THE MARKET


Carrie Schwab Pomerantz

Carrie Schwab Pomerantz is a Motley Fool contributor.

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