ETF vs Mutual Fund: Understanding the Key Differences

In today’s world, investing has become an integral part of financial planning. As people aim to grow wealth, investment vehicles like Mutual Funds and Exchange-Traded Funds have become famous for their flexibility, diversification, and income potential. But what is the difference between ETF and mutual fund?

While both offer unique merits, Mutual Funds and ETFs have distinct characteristics that serve varying investment approaches. This article will elaborate on ETF vs Mutual Fund, their functioning and types to determine which option better suits your portfolio.

Overview of Mutual Funds

Mutual Funds allow investors to participate in a professionally managed investment scheme by pooling money from individuals to invest in a portfolio spanning various securities like stocks, bonds, etc. The combined holding of assets constitutes the Mutual Fund’s portfolio, which fund managers administer in alignment with predefined investment objectives.

Fund managers decide which securities to buy, hold, or sell based on whether the scheme aims to deliver high capital growth, regular income, or both. By investing even small sums, investors can gain exposure to a basket of instruments that would otherwise be expensive to build individually.

When the fund’s holdings earn profits through capital gains or income, the earnings are distributed proportionately to all unit holders after deducting applicable expenses. Investors can conveniently purchase or redeem mutual fund units based on the net asset value declared by the fund.

Types of Mutual Fund Schemes

Mutual funds offer various scheme categories suited for different investment goals:

1. Equity Funds: These primarily invest in shares and target potentially higher returns over a long duration. They are appropriate for investors with a greater risk appetite and growth focus.
2. Debt Funds: With significant exposure to fixed-income assets like bonds, gilts, etc., debt schemes target stable income through interest payouts and cater to investors seeking lower volatility in returns.
3. Hybrid Funds: Blend equities and debt/money market assets, balancing risk-return profiles. They allow tapping into the twin engines of capital growth and steady cash flows.
4. Index funds: Replicate popular benchmarks like Nifty or Sensex by replicating their composition. They offer stability and transparency at lower costs.
5. Tax Saving Funds (ELSS): With primary equity exposure, ELSS offers tax deduction benefits under Section 80C while pursuing long-term growth. It comes with a 3-year lock-in period.

Overview of Exchange-Traded Funds

Exchange-traded funds (ETFs) also give diversified access to investment assets, similar to mutual funds. However, unlike mutual funds, ETF units are exchange-listed products that trade on stock markets. This facility allows investors to buy and sell ETF units multiple times during market trading hours, adding to convenience and liquidity.

ETFs are passively managed funds that monitor benchmark indexes, such as the Nifty 50, to reflect index performance rather than outperform it. Because this index-aligned investment approach does not involve active stock picking, ETFs tend to have lower operating expenses than mutual funds.

Types of ETFs

Exchange-traded funds come in many types, each designed to match distinct investment plans and money goals:

1. Equity ETFs: Track underlying stock indices, providing access to a basket of securities through a single fund.
2. Bond ETFs: Follow bond market indexes, giving exposure to diversified fixed-income securities. Offer relatively stable income streams.
3. Commodity ETFs: Offer investment exposure to the price movements of raw materials like gold, silver, crude oil, natural gas, etc. They move in alignment with fluctuations in underlying commodity prices, allowing participation in physical assets beyond just financial instruments.
4. International ETFs: These allow exposure to foreign markets, allowing geographical diversification. They also help tap growth beyond the domestic economy.
5. Sector ETFs: Allow concentrated play on specific industries, such as information technology, healthcare, energy, etc., riding their growth trajectories.

Key Differences: ETF vs Mutual Fund

While ETFs and Mutual Funds have their advantages, their functioning, trading flexibility, costs, and taxation tell us how is ETF different from mutual fund:

• Trading: Mutual Funds are directly purchased from and redeemed with the fund house. In contrast, ETFs are exchange-traded products bought/sold on stock exchanges via brokers.
• Pricing: Mutual Funds use a single end-of-day NAV for all transactions on a given day. Conversely, ETFs see price fluctuations throughout the trading session and are intraday tradeable securities.
• Management Style: Mutual Fund schemes actively purchase/sell assets aiming to outperform benchmarks, resulting in higher expense ratios. In contrast, ETFs predominantly follow a passive index-tracking approach with lower costs.
• Ideal Horizon: Owing to single NAV-based pricing, Mutual Funds suit longer-term buy-and-hold style investing. On the other hand, live intraday pricing allows using ETFs for shorter-term trading strategies.
• Taxation: Equity Mutual Funds enjoy tax benefits on long-term gains if held for over a year. ETFs do not have dedicated tax-saving provisions and attract taxes like listed stocks.

What is the Difference Between ETF and Mutual Fund

Conclusion

Mutual funds and ETFs serve two main investment approaches: active management, which tries to beat market returns by selectively choosing stocks, and passive investing, which mirrors market indexes. While mutual funds attempt to provide higher returns relative to benchmarks by handpicking shares based on research, ETFs gain from a more straightforward structure and lower fees.

Understanding ETF and mutual fund differences, such as real-time pricing for ETFs versus end-of-day pricing for mutual funds, is critical to informed decisions. Comparing aspects like active vs. passive management, flexibility, costs, and taxability according to one’s situation helps determine the better-fitting instrument.

Whether one prefers a more involved, actively managed route or straightforward index-tracking transparency, both mutual funds and ETFs hold the potential for portfolio growth, financial progress, and wealth creation over the long run. It is crucial to pick the option that aligns closer to one’s strategy and needs.

Frequently Asked Questions – FAQs

1. Are ETFs cheaper than mutual funds?

Yes, generally, ETFs have lower expense ratios than actively managed mutual funds since most ETFs are passively managed index funds.

2. Are ETFs more tax-efficient than mutual funds?

Yes, ETFs are typically more tax efficient, as they tend to have lower portfolio turnover than actively managed mutual funds.

3. Can ETFs be purchased at any time during the day?

Yes, ETFs trade on exchanges just like stocks, so they can be purchased whenever the markets are open. Mutual funds trade only once a day after the market closes.

4. Do ETFs pay dividends?

Yes, many ETFs pay dividends depending on the securities held in the fund. Like mutual funds, dividends are distributed to shareholders.

5. Are mutual funds safer than ETFs?

No, both ETFs and mutual funds carry risks depending on the assets they invest in. Neither is inherently safer than the other.

Author: All Content is verified by SMC Global Securities.