Both Mutual Funds and Exchange-Traded Funds are meant for pooled fund investment. They adhere to an indexed and passive strategy that attempts to replicate the benchmark indices that are represented.
What are Mutual Funds?
The mutual fund scheme is a portfolio that is generated by making an investment in a basket of debt securities, stocks by utilising the funds that are collected from several investors. The fund manager and research analysts the market trends, risk, volatility, etc. and then decide the sector and stocks for making the investment.
The Net Asset Value (NAV) indicates the returns on mutual funds. The NAV of the units are calculated at the end of the day and it is determined by the price of the underlying securities.
What are Exchange Traded Funds?
They are also like mutual funds in nature as the asset manager pools the money collected from numerous investors and invests in a basket of securities. They are a combination of mutual funds and stocks. ETFs are similar to mutual funds with respect to their structure and management. Also, they can be traded like stocks are traded.
The principle of passive investing is followed in ETFs. As per this principle, a particular index is mirrored according to which the ETF tries to replicate its performance. They are viewed as close-ended mutual funds.
Herein, the funds are raised initially and then ETFs are invested in stocks that mirror the benchmark index following which no further investments can be allowed.
Which one to choose?
While making a choice between mutual funds and ETFs, there are five factors that should be considered. These factors are ease of liquidating the assets, risk appetite, investment horizon, financial goals and tax-saving strategy.
It is important to note that ETFs offer higher returns along with flexibility. Whereas mutual funds require the investors to stay invested for a longer period of time that helps generate corpus for the future.
Advantages of ETFs include buying on margin or selling short because there is no minimum requirement. So much so that investors can trade just one share also. Additionally, the commission that is paid to brokers while trading ETFs is similar to those paid for regular orders. All transactions in ETFs take place in real-time.
Factors that influence the decision
- The major difference between the two is their buying and selling. The mutual fund units are traded at the closing NAV of that very day. Whereas, the ETF units are traded just like shares, on the exchange. ETFs can be purchased and sold throughout the day and their value differs during the day of the trade.
- The next imminent difference is the determination of the transaction price. In case of mutual funds, the investment is made at the fixed NAV. They are traded directly from the mutual fund house either offline, online or through a distributor. On the other hand, the ETFs are traded on exchange just like shares. This means you need to trade them through an authorised broker. Having an account with the broker and a Demat account is a must to trade ETFs. They can be traded throughout the day, thus their prices are determined by their demand and supply.
- ETFs are close ended, which means that once the funds are raised and portfolio is created, there are no additional redemptions or purchases. The liquidity for ETFs is through the demand for the units that are traded. On the other hand, fresh purchases and redemptions take place in mutual funds.
- The expense ratio is another major determinant of differentiation between the two. The expense ratio of ETFs is very low as compared to mutual funds. In the Indian context, the expense ratio of ETFs can be as low as 0.35% whereas for mutual funds the ratio can be up to 2%. The ETFs are however subject to brokerage and Securities Transaction Tax (STT).
- Mutual funds are comparatively more flexible than the ETFs. You can choose to invest in mutual funds using the systematic investment plan. However, such a facility is missing in case of ETFs.
It is important to study in detail and consider the above mentioned factors before making a decision while investing in ETFs and mutual funds. The choice will vary across individuals with regard to their risk appetite, preference of lock-in period, financial goals and the tax saving strategy.