Pay for performance: When you buy a mutual fund, you are not paying to be average. To be sure, fund managers take risks and lose many times. But fund managers with proven track records can earn superlative returns. Peter Lynch of Fidelity's Magellan managed 29 percent gains for more than a decade, turning a $20 million fund into $14 billion. No index has ever done that. But if you can avoid "shadow" funds, you might get the market-beating performance you want.
5. You get instant diversity when you buy an ETF. Investors have found ETFs to be a good way to diversify their portfolios. Dodd Kittsley, global head of ETP Research for BlackRock, says the rapid growth of ETFs is from "different assets classes and regions, allowing investors to put [exchange-traded products] to use in new ways." ETFs are widely used to buy physical gold, allowing direct ownership in gold bar certificates in funds like SPDR Gold Trust ETF (GLD). (Note that "ETP" is a slightly broader category than ETF, and includes exchange-traded notes and other ETF-like products.)
[Read: 7 Mutual Funds That Make Huge Bets.]
Limits to diversity: Be careful how you diversify, since some of the more exotic and specialized ETFs are prone to tracking errors, and some have already been closed after failing to win buyers. It's also worth remembering that an equity ETF has a different risk profile than an individual stock, just as a bond fund, with its floating yield, differs from the locked-down yield of an individual bond.
Not better or worse—just different. For investors, there is a basic strategy difference between ETFs and mutual funds.
"Active management has sometimes been trashed because the funds are more expensive. But shockingly, enough when things go badly, active managers have the ability to make decisions that index funds can't make," says Brooks Mosley, president of Security Ballew Wealth Management. "On the flip side, ETFs give investors access to sectors and countries that the average investor didn't have 10 years ago. If you are looking for cost-efficient ways, and not looking for total return, it's better to use an ETF."