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Anyone who has sat through portfolio prattle at a dinner party has probably heard plenty about the debate over exchange-traded funds versus mutual funds.

ETFs, the newer kid on the block (if you consider the early 1990s new) are gaining traction with investors who like their lower fees, exposure to broad market indexes and passive, couch potato approach. Mutual fund enthusiasts, however, point to experienced fund managers and products that offer the stock-bond-cash power punch, providing for lower volatility during tougher economic times.

But does an investor have to choose one product over the other?

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Not necessarily. Whether because of thoughtful planning or simple apathy toward selling underperforming or pricey funds, many Canadians own portfolios that merge mutual funds and ETFs.

"This blended strategy of having ETFs and active managers is going to be the new normal," says Thane Stenner, director of wealth management and portfolio manager of Stenner Investment Partners, which is part of Richardson GMP in Vancouver.

Here are five things to consider when combining the two types of funds.

How different are they really?

While the original ETFs were funds that simply tracked the markets, today's offerings – more than 300 of them in Canada alone – have come a long way in recent years. Some are industry- or geography-specific. Others, such as the iShares Jantzi Social Index ETF, entice investors who want to avoid weapons, tobacco and nuclear power companies in their portfolio. Want choice? You've got it.

In many respects, it's hard to tell the difference between some ETFs and their mutual fund counterparts, other than how they are purchased, says Christopher Davis, director of manager research at the independent investment research firm Morningstar Canada in Toronto. (Mutual funds are bought and sold via a fund company, while ETFs require trading shares with other investors in the market through brokers.)

"Investors should think of them as really the same thing. They're both just a diversified basket of securities," he says. "Ten years ago, the ETFs were just like index mutual funds. Today they're a lot more like active mutual funds."

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Even ETFs that offer ultimate diversification – one of the main reasons investors turn to them – share space with mutual funds. The Vanguard Total International Stock ETF (VXUS), for instance, seeks to track the performance of the FTSE Global All Cap ex US Index, which measures the investment return of stocks issued by companies in all countries other than the United States. The kicker? A couple of Vanguard mutual funds track the same index, too.

You want to save a buck

No doubt about it, ETFs tend to be cheaper than mutual funds, which, in Canada, charge some of the highest fees in the world. ETFs have lower overhead charges, with savings passed down to the investor through lower expense ratios. Use a discount broker and be prepared for a good deal.

"ETFs have anywhere from a 1.2-per-cent to 1.5-per-cent fee advantage over mutual funds per year," says Mr. Stenner, although for high-net-worth investors, who receive institutional pricing, that disparity shrinks.

An efficient market's friend

Efficient markets, those that are actively traded and quick to jump on new information, are good choices for ETFs. With little handholding needed from a manager or adviser, investors can easily go the DIY route and feel on top of their game.

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"ETFs are going to be an enormous challenge to mediocre and subpar mutual funds, no doubt about it," Mr. Davis says. "The only real reason to invest in a mutual fund, if there's an ETF alternative, is because you think the manager has superior skill."

The trick? Choose mutual funds in a category where managers add value (such as Canadian small- and mid-cap companies) and avoid them where they don't (think U.S. equities).

Loading up on carefully chosen mutual funds and ETFs makes sense in terms of hedging, as passive ETFs can smooth out a few bumps if you've chosen the wrong actively traded funds, and vice versa.

"Even for people who have superior skill in picking managers, they still benefit from having some of their portfolio in index funds," Mr. Davis says. "A lot of times, the best active managers perform inconsistently."

One word: flexibility

Long-term investors can skip this part. For the rest who are looking for the ability to trade throughout the day like they would with stocks, adding an ETF to a mutual fund-heavy portfolio might make some sense.

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Traditionally, the prices of mutual funds are set at the end of the day, and investors must order before. But ETFs are set up like stocks, meaning investors can trade all day. They also have to work with a broker. For someone who wants to look like a couch potato but act like an athlete, ETFs offer you the chance.

The E factor

There's obviously an emotional component when many investors build their portfolios. They get warm fuzzies about a company that sells their favourite phone, so they invest. They stick with a loser fund too long because they've had it for decades and can't imagine changing. They read a couple of articles espousing the benefits of ETFs and decide they better buy the hottest (read: most expensive) one.

Even those who buy a total market index fund, which offers the whole world at once, can feel they're not diversified enough to mitigate their risk. In that case, buying a mutual fund in addition to an ETF might seem to make sense. But before buying, it's important to look at what you already have so there's no overlap, Mr. Stenner advises.

"You can have the cheapest ETF or mutual fund, but if you don't get your asset mix correct, or chase performance, that emotionality around investment decisions throws most people off course."

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