ETF vs Mutual Funds – Key Differences & Things to Consider
In terms of investment strategies, ETFs (Exchange-Traded Funds) and mutual funds may not be so different. But there are some key differences that can affect your investment choice significantly. As an investor, you must know the key differences between ETFs and Mutual Funds to maximise returns and reduce risks. In this article, you will learn about ETF vs mutual funds to understand which will be the right fit for your investment goals. Read on!
What is an ETF?
An ETF or Exchange-Traded Fund is a relatively newer model of investment which is almost similar to mutual funds but has some very basic differences. Unlike mutual funds, ETFs don’t have any minimum investment amount and are traded on the stock market throughout the day. They are designed to mimic the performance of the index that they are replicating. These are passively managed funds and you can easily buy or sell them all throughout the trading session of a day.
What is a Mutual Fund?
A mutual fund is both actively and passively managed by fund managers and the Net Asset Value (NAV) changes in accordance with the value of the underlined assets. Unlike ETFs, mutual funds have a specific lock-in period for some specific schemes like ELSS, and withdrawal attracts a certain charge.
A larger, diversified portfolio of funds can be perfect for investors with a low-risk appetite. In addition, mutual funds have a large pool of investment options like bonds, debt instruments, stocks, etc.
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ETF Vs Mutual Funds
The table below details the key differences between ETFs and mutual funds:
| Differentiating Parameters | ETFs | Mutual Funds |
| Portfolio Management | The portfolios of ETFs are passively managed as they replicate the underlying index. | Mutual funds can be either actively managed or passively managed. |
| Trading | Investors can purchase or sell ETFs when they wish to as these investment options can be freely traded. The market price of an ETF undergoes changes throughout the day and is available on a real time basis. | To buy and sell mutual units, people have to place requests with the AMC. The units of a mutual fund are bought and sold at their NAV (Net Asset Value), which changes daily. |
| Commissions | Investors do not have to pay any type of commission on the purchase or sale of ETFs as they are traded on stock exchanges like other shares. | Investors do not have to pay commissions for the sale or purchase of mutual funds |
| Management Fees | ETF fees range from 0.05% to 1.00% | Mutual Funds fees range from 0.50% to 2.00% |
| Lock-in period | There is no lock-in period. Investors can sell off their investments whenever they wish to. | Mutual funds do not have lock-in periods. ELSS is an exception because it has a lock-in period of 3 years. |
| Liquidity | ETFs have higher liquidity as they have nothing to do with the daily trading volume. Moreover, their liquidity is related to how liquid their underlying stocks are. | When compared with ETFs, mutual funds have lower liquidity. |
| Expense Ratio | ETFs have much lower expense ratios than actively managed mutual funds. | Actively managed mutual funds can have an expense ratio as high as 2%. |
| Flexibility | No SIP facility is available for ETFs. If at all, you wish to invest manually, you have to do it manually. | Investments in mutual funds can be made periodically through SIPs which inculcates financial discipline among new investors. |
| Transferability | People consider ETFs to be portable investment options as the process of transferring the portfolio from one AMC to another is easy. | Mutual funds transferability is a complicated process Untimely closing of fund positions before transferring to a different AMC can result in losses. |
ETF Vs Mutual Funds – Similarities
Now let us look at some of the points where ETFs and mutual funds are similar:
1. Portfolio Diversification
The investment portfolio of both ETFs and mutual funds are diverse as they hold different stocks. As a result, if one underlying asset underperforms, others will make up for it. This brings down the overall risk level.
2. Pooling in of Money
Both ETFs and mutual funds pool money from many investors and use the funds to invest in various securities such as equities, debt instruments or commodities.
3. Professional Management
Both ETFs and mutual funds are professionally managed by experts. While ETFs always track an underlying index only passively-managed index funds do so. Though differences between the returns generated by indices and the investment options exist, fund managers try their best to minimise tracking errors.
4. Passive Investment Strategies
ETFs, just like some passively managed mutual funds, follow passive investment strategies. In other words, ETFs and passively managed funds like index funds mirror their underlying indices, i.e. they invest in the same proportion of securities as their underlying index.
3. NAV is there in Both the Options
The Net Asset Value or NAV of ETFs is calculated at the end of the day, like mutual funds. The rise and fall of NAV represent the overall performance of the ETF or mutual fund.
Which One to Choose between ETFs and Mutual Funds?
The answer to this will depend on an individual’s investment objectives and risk profile which are some of the essential factors to consider before investing in ETFs or mutual funds. Other factors to consider are investment tenure, tax savings strategies and liquidity.
Investors who prefer high liquidity and good returns for a short tenure can opt for ETFs which are flexible investment options and ideal for a short tenure. Others who wish to remain invested for a considerable time period and build a substantial corpus can opt for mutual funds.
An important thing to remember before making a decision is that investors need to open a Demat account and a trading account for investing in an Exchange Traded Fund in India. If someone is not comfortable with the idea of opening these accounts, they can consider investing in index funds that replicate underlying indices.
Things to Consider Before You Start Investing
Regardless of whether you choose to invest in an ETF or mutual fund, you need to keep some of the following pointers for higher profits or returns.
1. Risk Appetite
Risk appetite is the ability and inclination of the investor to deal with losses. Although mutual funds are considered to be less risky when compared to ETFs, both carry the same level of risk, which varies depending on the type of funds you choose to invest. For example, debt funds are relatively less risky when compared to equity funds.
2. Expense Ratio
ETFs have a lower expense ratio as it is passively managed, while mutual funds have a higher expense ratio as they are actively managed. A higher expense ratio will ultimately affect your returns.
3. Tracking Error
Tracking error is the standard deviation of differences between the return of an index fund and the index it is mimicking. Notably, the tracking error can vary from 1% to 2%.
4. Investment Goals
ETF and mutual funds can be good for long-term financial goals. However, one can create a more diversified portfolio in mutual funds compared to ETFs. With an ETF, one can also profit from short-term investments like money market instruments.
Final Word
When it comes to investment, several factors need to be considered before coming to any conclusion. ETF offers tax benefits, low commission and easy liquidity. But mutual funds provide higher returns depending on the mode and plan of investment. Higher risk yields more returns in long term investment. So, assess your financial goals, risk appetite and other factors before you make an investment choice. If you are ready to invest, visit Navi Mutual Fund and get started today!
FAQs
There are three main types of mutual funds segregated depending on risk factors. They are equity funds, debt funds and balanced or hybrid funds. Among these three, equity funds provide higher returns but high-risk factors.
ELSS or Equity Linked Savings Scheme comes under equity fund schemes. It has a minimum investment limit of 80% in stocks and was announced by the Ministry of Finance in 2005. It has a lock-in period of three years and is eligible for tax deduction under Section 80C of the Income Tax Act.
Arbitrage funds profit from the difference between the same asset prices in two different markets by the simultaneous purchase and sell. This is considered a good option to profit from volatile markets without taking too much risk.
As the name suggests, hybrid funds are funds that invest in different asset classes. Primarily they invest in equity and debt funds in different proportions. On the other hand, balanced funds invest in stocks and instruments in equal proportions. These funds offer stability and come with low risk.
Indexation benefits can be availed in case of long term capital gains if the gain is derived from the sale of debt mutual funds. This allows the investor to recalculate and increase the purchase price of any asset to adjust the effect of inflation.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
