Whenever investors are looking to invest their money, a financial advisor will likely recommend several investment options that include ETFs (Exchange Traded Funds) and mutual funds. ETFs and mutual funds have certain similarities among them. However, some key differences between ETFs and mutual funds set them apart. Both of them have a variety of different assets. Also, they represent a common avenue for investors to diversify their portfolio.
Here, in this article, we will explain exchange traded funds ETFs vs mutual funds in detail.
What is an Exchange Traded Fund ETF?
Exchange Traded Funds are passive investment instruments that merely replicate an index. In other words, the portfolio of an ETF matches the composition of an index in the same portion. ETFs track the performance of an index. Hence, they are not actively managed by a portfolio manager. Also, these funds do not attempt to outperform the respective index.
One can easily buy and sell ETFs on a stock exchange. The price of the ETF can fluctuate throughout the day. The market price is determined based on the Net Asset Value of the underlying assets or stock in it.
There are different types of ETFs. Some of them are current ETF, bond ETF, inverse ETF, equity ETF, commodity ETF, gold ETF etc.
What is a mutual fund?
A mutual fund is a professionally managed financial instrument. It pools money from different investors. The money pooled is invested in securities like stocks, government bonds, corporate bonds and money market instruments.
An asset management company manages the mutual fund. The first step starts with pooling money from investors. Mutual funds invest this pooled money in building a portfolio of different asset classes like equity, debt money market instruments and other funds. Therefore, an investor has an advantage of diversification through mutual funds. For instance, mutual funds invest in government bonds. As a retail investor, it gets difficult to afford such high-value bonds.
A mutual fund is managed by a team of experts and fund managers who pick all the investment to build a portfolio. The fund manager makes investment decisions according to the objective of the mutual fund. Therefore, a mutual fund is an actively managed fund by a fund manager. Since investment in the stock market requires a lot of research and time, mutual fund investments come with this advantage. Thus, investors need not worry about studying the stock market.
The market value of the portfolio depends on the price movement of the underlying assets. The portfolio value is the total net assets divided by the number of outstanding units. This is called NAV or Net Asset Value. The higher NAV reflects the portfolio gains, whereas lower NAV indicates a loss in the portfolio value.
Mutual funds can be broadly classified as a equity funds, debt funds (Fixed income fund) and hybrid funds. An equity fund predominantly invests in equities or stocks of companies. A debt fund, also known as a fixed income fund invests in debt securities. Whereas, a hybrid fund, invests in both equity and debt securities in varying proportions.
Exchange Traded Funds ETFs vs Mutual Funds
Though ETFs and mutual funds look very similar, the following are the significant differences between ETFs vs mutual funds.
ETFs are passively managed portfolios. These funds merely track the index. On the other hand, mutual funds are actively managed funds by a fund manager. A fund manager comes with market knowledge expertise and helps investors to manage their assets. They take all the investment decisions on behalf of the investors.
ETFs are freely traded in the market. Investors can buy and sell as per their convenience. The market price of an ETF is available on a real-time basis, just like ordinary equity shares. In simple words, the price of the ETF changes throughout the day. However, investors can buy and sell mutual fund units only by placing a request with the fund house. Its NAV determines the market price of the fund. Hence, NAV indicates the price of each unit of a mutual fund.
ETFs do not need active portfolio management as they replicate the performance of the index. Hence, the fund management fees and other expenses associated with ETF investments are low. While in the case of mutual funds, the fund manager actively takes investment decisions on behalf of the investors. Hence, the fund management expenses are higher. The reason is, these fees are reflected in the expense ratio of the fund. The higher the fees, the higher the expense ratio of that particular mutual fund.
ETFs are traded like any other share on the stock exchange. As a result, investors need not pay any commission on sale or purchase of any units as per the prevailing rules. However, one need not pay any commission for sale or purchase of any mutual fund.
When an investor decides to move their managed portfolio to a different investment firm, a complication can arise at that time. In the case of ETFs, the transferring is very clean and straightforward while switching investment firms. They are considered as portable investments. While in mutual funds, transferability is a bit complicated. One needs to close the fund positions before transferring the funds to different investment firms. This might be a problem for investors, as some untimely closure of investments can result in losses.
ETFs have higher liquidity since it is not connected to the daily trading volume. ETF liquidity is related to the liquidity of stocks included in the index. However, mutual funds have lower liquidity in comparison to ETFs.
ETFs track an index, i.e. it tries to match an index’s price movements and returns by assembling a portfolio similar to the index constituents. On the other hand, mutual funds are actively managed by professionals who follow index tracking. The fund managers pick the assets of the portfolio to beat the index and achieve higher performance.
ETFs do not have any minimum holding period. The investors are free to sell the investments as and when they like. Mutual funds like ELSS fund (Equity Linked Saving Scheme) have a lock-in period of 3 years. During this time frame of ELSS fund investment of 3 years, investors cannot liquidate their investment. Also, an ELSS fund is a tax saving tool. There are different lock-in periods which range from 9 days to 3 years, depending on the type of mutual fund scheme.
ETF or Mutual Fund- Which one to choose?
Both the investment options, i.e. ETF and Mutual Fund, help investors build a diversified investment portfolio. However, there are many factors that one must consider before choosing a fund. The factors such as
- Investor’s risk tolerance level
- Investors time horizon
- Investor’s Financial goals
- The tax savings strategy
- Liquidity of investment
Once the investor has narrowed down the above, they can choose to invest in ETFs vs mutual funds based on their requirements. For some investors, liquid investments take precedence over long term investments. Exchange Traded Fund ETFs offer more flexibility and better returns in the short term. At the same time, investors who invest in mutual funds must stay invested for a more extended period which helps them create a corpus for the future. The decision depends on the investor as one must consider all the factors before choosing to invest in an ETF or mutual fund
Additionally, there is another practical point to note before choosing to invest in an ETF. An investor must have a demat account or a trading account to invest in an Exchange Traded Fund in India. If an investor is not comfortable opening a demat account or a trading account, ETFs are not appropriate for them. However, investors can choose to invest in passively managed indices through index funds. Index funds are a type of mutual fund scheme that mimics the portfolio composition of a market index. For instance, an investor can choose to invest in an ABC ETF Nifty 50 index fund of a fund house.
The nature of both ETFs and mutual funds is very similar. An investor can make a wise and healthy mix of these investment instruments to build a diversified portfolio. However, as an investor, they must understand the functionality of both these funds. Also, investors must assess the market risks they are willing to take. It is also advisable to consult a financial advisor before making an investment decision.