Mutual funds and exchange-traded funds, or ETFs, are among the most popular investments among the general masses. There are similarities between the two; however, there is an important difference that makes them unique from each other. Strangely enough, technically, ETFs are a type of mutual fund, but under certain unique features, investors sometimes view them as separate investment avenues. This article will help in understanding the differences between mutual funds vs. ETFs, which will further guide in decision-making with respect to investment.
What are Mutual Funds?
Mutual funds are those investment vehicles wherein the moneys of a multitude of investors are collectively pooled, thus forming a diversified portfolio of stocks, bonds, or other securities. The pooled money is then invested by the professionals known as fund managers for generating returns with clear selections of assets after proper and comprehensive research.
You buy units representing fractional ownership in the entire portfolio whenever you invest in a mutual fund. Since the NAV of the mutual fund units is determined at the close of every trading day, the value of your investment is measured that way. Hence, for instance, if the mutual fund units that you had invested in are performing well, the NAV would increase to reflect the positive performances of its underlying assets in the fund, and vice versa. This makes mutual funds so dynamic—a dynamic way to participate in the financial markets.
What are Exchange-Traded Funds (ETFs)?
Exchange-traded funds are similar to mutual funds in the sense that they accumulate funds of various investors into a diversified portfolio of assets—stocks, bonds, or commodities. Whereas mutual funds represent securities, exchange-traded funds, on the other hand, trade on a stock exchange throughout the trading day, much like individual stocks; hence, trading, buying, and selling are very possible even intraday at any moment with liquidity.
ETFs are characterized by a passive investment strategy, and they seek to replicate the performance of the index rather than outperform. For example, some ETFs track the Nifty 50 or S&P 500 and replicate its composition as well as performance. ETFs are essentially closed-ended in nature, unlike conventional mutual funds. After collecting the initial fund, the ETF invests in securities to mirror the index, and no more fund-raising is done thereafter.
Mutual Funds vs. ETFs: Basic Differences
| Mutual Funds |
ETFs |
| Management Style |
| Mutual funds are typically managed actively, where the mutual fund managers rely on their abilities and expertise to choose assets that they believe will outperform the market. Some mutual funds, such as index funds, are passively managed, just like ETFs. |
ETFs fundamentally operate through passive management, where they aim at tracking a specified index. The fund manager does not quite change the portfolio at frequent intervals and thus makes ETFs inexpensive in terms of management charges. |
| Trading Method |
| Mutual fund units are bought and sold directly at the fund house or through a distributor. The transaction is at the time of the net asset value calculated at the end of the trading day, which therefore leads to equal buying and selling prices for all investors. |
The units of an ETF are traded on stock exchanges within a day, just like stocks. This, once again, gives an investor the opportunity to take advantage of intraday prices. To trade in ETFs, you would require a Demat account to hold the units. |
| Liquidity and Accessibility |
| As the units of a mutual fund are traded only at the end of the day, there's a slight liquidity deficit compared to that for an ETF. Here, you don't need to have any Demat account to invest in a mutual fund. |
Here, as an ETF, you can buy and sell units anytime during the trading day. So, liquidity is better. However, a Demat account is needed for ETFs. |
| Cost Structure |
| Actively managed mutual funds are expensive because of a high expense ratio from the management fees. The passively managed mutual fund is the index fund, and it has low costs, but that is more than an ETF. |
ETFs have low expense ratios because of their passively managed approach. Since ETFs are traded on a stock exchange, there is a possibility of having a brokerage fee when buying or selling units. |
| Minimum Investment |
| The minimum sum required to invest in a particular fund changes, but with the systematic investment plans, even a small amount can be used. |
The cost of investing through ETF would be on the price prevailing in the market for the units. For instance, if the price of one unit of an ETF is 1/100th of the value of the underlying index and the index at which it is trading is at 2,000, then one unit of the ETF would be available at ₹20. |
ETFs vs. Index Funds: A Common Confusion
In theory, the very simple fact that both ETFs and index funds are passive investment vehicles contrasts them. A fund index is basically a specific kind of mutual fund that is meant to replicate a certain index by investing in those stocks or bonds that the index contains. Contrariwise, an ETF trades like stocks while its price continues to fluctuate through the day from sellers and buyers.
Conclusion
Different benefits exist from each, and so which is more suitable depends on your investment goals, risk profiles, or preferences. Mutual funds, especially the actively managed ones, may be most suitable for those who would like professional management and a very hands-off approach, explore this link to get a holistic understand about mutual funds. ETFs, being relatively lower in costs, coupled with trading flexibility, might be more apt for people who can take a more hands-on investment style. Knowing how mutual funds and ETF differ will help a learner set up an optimized investment portfolio with well-informed decisions.