Fueled by retirement plans, strong investment markets (the last 10 years notwithstanding) and convenience, mutual funds have been the vehicle of choice for most individual investors for well over 30 years. Still, mutual funds are not without their shortcomings and a challenger to their supremacy is on the rise.

“Mutual funds” typically refers to open-ended mutual funds which are bought and sold at each day’s closing price directly from the mutual fund company. There are mutual funds for a wide range of securities (stocks, bonds, etc.) and with a confusing array of objectives and strategies.

Mutual fund fees can have a dramatic impact on performance. These fees, which are deducted from income before that income is distributed to the shareholders, include the fund’s operating expenses, the brokerage fees paid by the fund when it trades securities and, in many cases, marketing fees. Another drag on performance is the cash that funds must hold to pay shareholders who want to sell their shares. The average fund holds around 3% of the fund in cash, and in a rising market this uninvested money means less gain.

Mutual fund investors are also their own worst enemy. Because investors can’t resist the urge to jump in and out of funds, rather than holding them for longer periods, they do not participate in full market gains. Dalbar, an investment research firm, estimates that the average stock fund investor realized annual gains of only 3.49% in the 20 years ending in 2011. That is a far cry from the 7.81% average annual return of the S&P 500 for the same period. Investors’ impatience, fear and greed lead them to buy high and sell low.

Exchange-traded funds (ETF’s) are the new darlings of investing. ETF’s are closed-end funds which trade all day between investors on the open market, similar to stocks, rather than involving the fund company. This eliminates the need for the ETF to hold extra cash and makes available all the trading techniques an investor may use for stocks. More important, ETF’s include a mechanism which keeps the market price at which they trade very close to the underlying value of the securities held by the ETF.

ETF’s have surged in popularity, with some financial advisers completely abandoning mutual funds for ETF’s. ETF’s now cover very obscure and targeted areas of investing, some of which are not practical for mutual funds. In 2003 there were approximately 136 ETF’s; at the end of 2011 there were 1,166. ETF assets were around 3% of mutual fund assets in 2003 and tripled to over 9% in 2011. Cash flow (an indication of where investors are adding new money) for ETF’s went from 6% of total cash flow for all long-term funds in 2003 to 62% in 2011.

A deeper look at ETF’s exposes a bit of hype. Most ETF’s use an index strategy in which the fund replicates a particular segment of a market (small US stocks, for example) and seldom makes changes in its holdings. Indexing reduces both operating and brokerage costs. However, comparing ETF’s to actively managed mutual funds (in which the fund manager buys and sells investments based on the manager’s assessment) is comparing apples to oranges. There have long been mutual funds which pursue indexing, and while it is an interesting academic exercise as to which is better, if an investor has made the decision to index there is little difference between an ETF and an index mutual fund. Long-term returns are also influenced by reinvestment of dividends, which is a “default” for mutual funds but which may require further action by an investor in ETF’s.

Ironically, many advisers have for years disparaged index funds as “settling for mediocrity”. This has been especially true of advisers who get paid by the investment products they sell, because a high-cost index mutual fund which includes compensation to the adviser makes no sense and defeats the purpose of indexing. Now, advisers can buy index investments through ETF’s and make money through the transaction fees.

What about the trading mechanisms available to ETF’s, which certainly allow investors to more closely manage their holdings? This is an advantage of ETF’s, if trading is a primary goal. But these trading mechanisms also increase the likelihood that investors will make impulsive, short-term decisions and further disadvantage themselves compared to long-term investors, as illustrated by the Dalbar study. And who makes money from these short-term trades? Advisers and brokerage firms.

ETF’s are a legitimate investment vehicle which fit nicely with many investment strategies. They do not, however, magically solve the puzzle of developing a long-term plan to meet specific goals and objectives. The tried-and-true considerations of proper portfolio diversification, low costs and low portfolio turnover still apply, regardless of the tool used.