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In order to understand the difference between the two concepts, let us look at their meanings first.
Mutual fund investments are financial avenues wherein a number of investors (people or entities) sharing a common financial goal invest capital. This pool of money is maintained by a fund manager who is in charge of the actual investment of the money into equities, bonds, money market instruments and/or other securities, in accordance with the risk profile of the investors. In this manner, each investor owns units of the fund, which are essentially a portion of the holdings of the fund.
The income or gains generated from this collective investment fund are then distributed amongst the investors proportionately. This involves some computation, mainly the calculation of the mutual fund scheme’s Net Asset Value (NAV).
ETF or Exchange Traded Fund is an investment fund traded on the stock exchange. These may seem more complicated and full of jargon, but simply, the assets held under an ETF are commodities, stocks and bonds and are traded for an amount close to the original net asset value of the asset, during a trading day.
ETFs track a bond index or stock index and therefore, have more interaction with the market. Which also explains why the price of the ETF can vary throughout the day.
Since ETFs are more in touch with the markets, they can be used for the purpose of hedging, arbitrage etc. ETF shares are usually traded on public stock exchanges, so these shares can be transferred, bought, or sold easily like the shares of stock.
The profits given to the ETF shareholders are the dividends or the interest earned, along with the residual in case of liquidation of the fund.
ETF shareholders get a part of the profits, i.e, the dividends paid and interest earned. They may also get a residual value if there is a liquidation of the fund.
There are major differences between mutual funds and exchange-traded funds (ETFs) that you should know before investing.
Let’s start the comparison with their similarities.
Both mutual funds and ETFs are diversified investments because they enable investors to buy a basket of securities within one investment avenue. The objective of such an investment, whether growth, value or income, defines the category of stock or bond.
The other similarity is the management of index Mutual funds and ETFs. Both are managed passively and therefore have a lower expense ratio when compared to actively-managed funds.
All in all, both are a robust option for portfolio construction and diversification. So then how does one decide between a Direct mutual fund and an ETF? Let’s address this conundrum by looking at the differences between the two financial tools.
The first and foremost difference between Mutual funds and ETFs is in the mode they are traded. In other words, investors buy and sell the shares differently under both options. For mutual funds, your buying and selling prices are actually the NEt Asset Value, calculated at the end of a trading day. So any fluctuations in the prices during the day do not matter.
On the other hand, in the case of ETFs, trading is done intra-day. So, if you are able to take advantage of the price movements during the day, then this can be a benefit over mutual funds. The price fluctuations during the day present both risk and opportunity and it will require some prediction skills to get it right.
The second parameter is flexibility, specifically one that arises out of the control on the sale and purchase. ETFs can be bought and sold at any time as per your convenience because their real-time market prices are available. For mutual funds, however, sale and purchase are only done through the fund managers. Moreover, the price is indicated through the NAV.
Another set of parameters that differentiates between the two are the fees and expenses incurred in the process. ETFs are only passively managed so the fees and expenses incurred in their transactions are low. On the other hand, mutual funds are managed actively by fund managers who are often part of an Asset Management Company (AMC). Thus, fund management expenses are high. It is likely that the AMC fees reduce returns on a regular mutual fund option plan.
Drawing from that, mutual funds are managed actively by an experienced fund manager. Thus, the investors are able to reap the benefit of the experience and expertise of a fund manager who takes investment decisions. In contrast, ETFs track the market index and there’s minimal management involved.
Finally, the concept of lock-in period plays into these avenues. In the case of ETFs, there is no minimum time period for which you have to hold the funds. You are free to sell the investment when you feel fit. But there is a category of mutual funds called the Equity Linked Savings Scheme (ELSS) that comes with a lock-in period of 3 years, during which you cannot liquidate your funds.
Now that we know the features and investment patterns of both the options, the question remains: how do you decide which one to go for? Both of them are, after all, great investment options for a diversified portfolio.
Here are some guiding factors you should consider when investing in a Direct mutual fund, online on Finserv MARKETS:
How easy is it to liquidate the investment?
What is the level of risk you are comfortable with, i.e what is your risk profile?
What is the investment horizon you are looking at - long-term or short-term? For your guidance, ETFs offer you more flexibility and higher returns in the short-run while mutual funds require you to stay invested for a comparatively extended period but help create a corpus for the future. This brings us to the next consideration.
Which tool can better help you reach your overall financial goals?
Is there a tax-saving goal you are trying to meet?
Keep in mind that for building a solid, diversified portfolio, mutual funds and ETFs can go in tandem with each other. You can look at it through intersections and sectors, for instance, one may look at Mutual funds for active management of particular sectors, and ETFs for sector funds.
Ultimately, it is up to your risk profile and return goals.