“OK,” said Sarah. “We know that stocks should be a serious part of our portfolio. But Mark and I don’t have time to study things like corporate balance sheets, chief executives, market share, new technologies and competitive products.”

Mark nodded.

“So mutual funds and exchange-traded funds make sense. But we’re unclear on the advantages and disadvantages of each,” she added.

I smiled. “Let’s start with Sarah’s 401(k) plan.” Sarah’s employer would match her 401k contributions each year up to $2,000. I advised her to make an annual contribution of at least $2,000. That’s an immediate 100 percent return on investment! As it happened, her employer offered her open-ended mutual funds.

“Which is what exactly?” she asked.

Open-ended mutual funds pool assets of many investors and offer a specific investment goal and strategy. Each share has a net asset value (NAV), representing the fund’s total assets divided by the number of shares. Investors buy and sell shares according to the NAV, fixed at the end of each trading day. Mutual funds offer some sound advantages:

• Guaranteed purchase and sale at the NAV

• Simple reinvesting of dividends

• Ability to switch funds within the same family, usually with no extra fees (though taxes may apply)

It’s wise to invest in “no-load” funds, which don’t charge fees to purchase shares. Their expenses should fall below 1 percent of assets for domestic funds and 1.50 percent for international funds. But it’s total cost that counts. This includes both fund and adviser fees. To help maximize your returns, you should want that to be less than 1 percent.

There is some downside to mutual funds. They can be purchased or sold only at the end of the day. The NAV may go down as well as up between the start of a session and its end. And that session can be volatile. When you put in a buy-or-sell order in the morning, you can’t be sure how much you’ll pay or get back until the market closes. Also, expenses are generally higher than with exchange-traded funds (ETFs) and are often less tax-efficient. The details of any fund, including expenses, can be found in the fund’s prospectus. This is required reading!

“So you favor ETFs?” Mark asked.

I do and here’s why: Exchange-traded funds track indexes, not individual stocks. Yet ETFs trade like stocks throughout the day, experiencing price changes throughout the day. You’ll buy or sell pretty much at the price you see the moment your order is placed. Very important for investors who like to sleep at night, ETFs are basically passive. The purpose of an index fund is to track a segment of the market, even the whole market. You’re not dependent on a fund manager’s evaluation of market conditions and individual stocks to achieve your investment goals. Over time, this conservative approach can build assets considerably for patient long-term investors. Also, ETFs offer:

• Lower expenses than mutual funds

• Greater tax efficiency by generating fewer long-term capital gains

• More flexibility for fund managers with which to protect investors

Still, you need to look under the hood of an ETF — read the prospectus — to understand what you’re buying.

 “Sounds great,” said Sarah, “but what about disadvantages?” There are some, I said, including a small measure of error in tracking component stocks, as well as more difficult and expensive dividend reinvestment.

So how do investors make important decisions about buying mutual funds and ETFs?

 “That’s your job,” said Mark.

“We have a financial adviser for a reason,” Sarah added.

I couldn’t have said it better. To start, I guide my clients primarily to ETFs for the above reasons. Also my custodial broker-dealer offers a choice of over 100 ETFs, all transaction-free. This lowers client expenses significantly while enabling me to meet clients’ financial objectives with greater accuracy. One size does not fit all.

I’ll be the first to state that investing can be complicated. If you’re a day trader, buying and selling individual stocks all the time, good luck. If you’re like most investors, you want to rid yourself of the burden of picking stocks and taking major risks. Understanding the roles of mutual funds and exchange-traded funds can help. n

Ira Fateman is a certified financial planner at SAS in San Francisco who conducts free personal finance workshops for Hebrew Free Loan (www.hflasf.org/financialfitness). Reach him at [email protected]