In last week’s post, I extolled the virtues of long term investing in low cost, index mutual funds. A regular reader and friend, Kim Ledbetter, pointed out that Exchange Traded Funds, or ETFs, are a great alternative, and he is absolutely right.

ETFs, like mutual funds, allow investors to buy an entire portfolio of investments by buying shares of the fund. Most ETFs are index funds, and there are ETFs to track just about every imaginable investment index there is. ETFs are different than mutual funds in that they trade like stocks on the stock exchanges with prices changing throughout the day in line with the index they track. Mutual funds are bought and sold through the fund company that manages them, and they are priced only once a day based on the ending price of the underlying investments. To own an ETF, you must have a brokerage account. You can’t purchase them directly from the fund company like you can with a mutual fund.

ETFs have three advantages to investors over mutual funds. For small investors who may not qualify for the lower cost institutional share classes offered by some mutual fund companies, ETFs have lower expense ratios. The expense ratio is the cost to manage the fund expressed as a percent of the fund value. The oldest ETF, the SPDR 500 ETF has an expense ratio of .0945%, or 9.5 cents for every $100 of investment value. That is quite low relative to the Vanguard 500 Index fund which has an expense ratio of 0.17%. Not all ETFs are created equal from an expense stand point though. The Vanguard S&P 500 ETF has an expense ratio of 0.05%. ETFs based on more obscure indices have higher expense ratios and may not be as competitive relative to mutual funds.

Another benefit for small investors who own their investments through brokerage firms like Charles Schwab is lower transaction costs. Low cost index mutual funds often don’t provide any compensation to brokerage firms, so the transaction costs to buy them can be quite high. To buy or sell the Vanguard Index 500 fund through Charles Schwab, for example, could cost you as much as $76 per transaction. However, you can buy any ETF for about $9 per trade, because the transaction is treated like a stock trade.

For taxable investments, outside your individual retirement accounts, ETFs provide a tax advantage as well. With a mutual fund, transactions in the underlying portfolio generate gains and losses that are passed through to the investors. So you may realize a taxable capital gain on your mutual fund holding even if you have never sold any shares. Trading activity in index mutual funds is generally low, but all funds have to make trades to realign to their index and to meet redemption requests. With an ETF, you only realize a gain or loss when you sell your shares. For long term investors, this can reduce your taxable capital gains in a given year and give you control over when you realize them.

ETFs are a great alternative to index mutual funds for managing your investments. Those based on major market indices offer lower expense ratios and trading costs than most index mutual funds, and for taxable investors, they offer better control over when a taxable transaction occurs.