Mutual funds and exchange-traded funds (ETFs) are two prominent investment avenues. These two have a lot of similarities but there are some notable differences between them as well. To be sure, ETFs are actually a type of mutual fund only but with special characteristics. So, many investors consider them as different avenues, while in reality, they aren’t. In this article, we will discuss mutual funds vs ETFs and help you understand them.
What are Mutual Funds?
As many of you may be aware, amutual fund schemeis a portfolio created by investing in a basket of stocks, debt securities with funds collected from several investors. Based on a team of research analysts, the fund manager decides which sector to invest in and within the sector the stocks to choose or, in the case of debt funds, the debt securities to invest in.
So, when you buy a mutual fund unit, you are essentially purchasing a portfolio of securities in a minuscule fraction of the whole. The returns you get on a mutual fund are indicated by thenet asset value (NAV)of the units calculated at the end of the day. The NAV moves in line with the price of the underlying securities.
What are Exchange Traded Funds (ETFs)?
Exchange Traded Funds (ETFs) are also Mutual Funds in the sense that the asset manager invests in a basket of securities by pooling money collected from many investors. ETFs can be based on a variety of asset classes like Equity, Debt, Gold, etc. In nature, they are a combination of the features of mutual funds and stocks. While in structure and management, they are similar to mutual funds, they can be traded like stocks on the stock exchanges.
They follow the principle of passive investing. Under this principle, the ETF mirrors a particular index and tries to replicate its performance. This is different from active investing, wherein the aim is to beat the benchmark index’s returns. ETFs are like close-ended mutual funds, wherein all the funds are raised initially, and then the ETF invests it in stocks mirroring the benchmark index with no further investments being allowed.
Mutual funds also follow the passive way of investing through funds calledIndex Funds, often confused with ETFs. While the objective for both is to mirror the underlying index, there is a difference. In an Index Fund, the fund manager creates a portfolio that exactly mirrors the index. If the Index has 50 stocks, the fund will also have those 50 stocks. However, an ETF is a fraction of shares in the index. For example, if an ETF is 1/100thof a benchmark index and the index level is 1256, then one unit of the ETF will be available at Rs 12.56.
Unlike mutual funds, ETF units are traded on exchanges just like shares of companies. Since they are traded on the exchange, they require a Demat account to be held by the investor for the purpose of stock market transactions.
Mutual funds vs. ETFs: How are mutual funds and ETFs similar?
- Both Pool Money from Multiple Investors
One of the similarities between mutual funds and ETFs is that the funds from a range of investors are pooled together and that money is put into a bunch of securities, which can be equities, debt, or a commodity like gold. Professional experts then manage this pool of money.
- Both Offer Diversification
Both mutual funds and ETFs benefit from diversity because they are a bundle of various stocks. So, if one stock performs poorly, there is always a possibility of another performing well. This helps you in hedging your risks. Diversification also makes them less risky in comparison to investing in individual stocks.
- Both Follow Passive Investment Strategies
Both ETFs and index funds (a type of Mutual Fund) follow the passive investment strategy wherein the investments are made in securities in the same proportion as the index they follow. This means that the weightage of each constituent in the index will have the same weightage in the fund. They both aim to deliver market returns at a low cost.
- Both Provide Professional Management
Both ETFs and mutual funds are managed by experts. The aim is to replicate the benchmark’s returns in both cases. In reality, differences between the returns do exist, and experts try to minimize these differences.
- Both Have NAVs
Like mutual funds, ETFs also have net asset values calculated at the end of the day. Both derive their value from the underlying assets they invest in, and the net asset value is also calculated in the same manner. In both cases, the rise and fall in the value of NAVs represent the mutual fund/ETF performance.
Mutual Funds vs ETF: The Difference
| Mutual Funds vs ETF: The Difference | |
| ETF | Mutual funds |
| ETFs can be actively bought and sold on exchanges, similar to individual stocks. | Mutual fund units can generally be purchased from the fund house or through authorized intermediaries. |
| ETF units can be purchased and sold anytime during market hours, at the prevailing market price. | While mutual fund units can be bought and sold anytime, the applicable NAV is determined as per the specified rules. |
| There is no minimum lock-in period for ETFs, allowing investors to buy and sell at their convenience. | Mutual funds also don’t often have a minimum lock-in period. But there can be an exit fee called the exit load for early redemptions, as specified in the scheme. |
| ETFs are typically passively managed. | Mutual funds can be both active or passive, depending on their type and construct. Passively managed mutual funds include index funds and funds of funds (FoFs). |
| ETF expense ratios could be as low as 0.35%. | An active mutual fund could have a total expense ratio of up to 2%. Expense ratios eat into the returns of funds, so the lower the expense ratio, the better. |
| ETFs are traded on stock exchanges, and their prices can fluctuate throughout the trading day based on supply and demand. | Mutual funds are not traded on stock exchanges, and their prices are typically determined by the net -asset= value (NAV) calculated at the end of each trading day. |
Bottom Line
Vandana’s biggest question now is – should she invest in an ETF or a mutual fund? The idea of buying the market, so to say, has caught her fancy, and she would like to experiment. Well, that would depend upon her risk appetite and whether it would suit her investment philosophy.
If she wants a passive fund that follows an index but doesn’t want the hassle of opening a broker account, she would be better off investing in an index fund and making periodic additions. On the other hand, if she wants a more active role in managing her funds and wants to take advantage of market fluctuations, she can opt for ETFs. A third option is to invest small amounts in both and then take it from there, depending upon returns and comfort. At the end of the day, apart from returns, you also need to look at how easy it is to invest, whether you understand the product, and your risk appetite.
So, let’s leave Vandana with this thought and wish her success in her investment journey.
