What are mutual funds?
Mutual funds are a kind of investment vehicle that pools the investors’ funds and invest in monetary instruments like bonds, stocks, short-term money market instruments, and other securities and assets. These funds are registered to the Securities and Exchange Board of India (SEBI). The portfolio is created as per the investors’ risk tolerance and is managed by a registered portfolio manager. Each share of the mutual fund is owned by an individual investor and represents their proportionate income generated. The mutual fund shares are directly purchased from and sold to the mutual funds themselves, either directly or through professional brokers.
A mutual fund can be classified into an open-ended or close-ended fund according to its maturity period.
Open-ended funds are usually available for subscription or repurchase on a continuous basis. These funds have no fixed maturity period, and as such, investors can buy or sell the units at Net Asset Value (NAV), which is declared on a daily basis. Open-ended funds are featured by their ease of liquidity.
On the other hand, a close-ended fund has a fixed maturity period of usually 3 to 5 years. Investors can subscribe to and invest in the fund only during a fixed period when the fund is launched. After that period is over, the units of the fund can be bought or sold on the stock exchanges where they are listed. As an exit route to the investors, few close-ended funds provide an option of selling these units back to the mutual fund at NAV-related prices through periodic repurchase. SEBI Regulations stipulate that either a repurchase facility is given to the investors or the fund units are listed on the stock exchanges.
One of the major benefits of mutual funds is that the investments are made in smaller amounts, making the entire process extremely flexible. For instance, if an individual opts out for a systematic investment plan or SIP, it is either monthly or quarterly. This helps them invest as per the budget they have for the investment purpose. It also takes one of the factors into consideration that is the best tax saving option. Different schemes taken under the Government of India can be beneficial for the investor at large because there are several benefits pertaining to the tax-saving that he or she can avail according to the Income Tax Act, 1961.
Can you trade mutual funds like stocks?
The answer is negative; We cannot trade a mutual fund like a stock. Though a mutual fund cannot be traded in the stock market as a whole, the units of these funds can be. The mutual fund units that can be traded in the stock market are called Exchange Traded Funds or ETFs. ETFs are not the same as the mutual fund units that an investor buys or sells from an Asset Management Company or AMC, either directly or through a distributor. ETFs do not require an AMC to deal with investors or distributors directly. The units are usually issued to Authorised Participants or APs, who are designated, large participants. The investors can buy and sell the ETFs on the stock market based on the price quoted by the APS. Thus, ETFs can be traded in the stock market like stocks, and it is a prerequisite for investors to have trading or demat accounts. Also, ETFs experience price fluctuations throughout the day, like stocks.
How are ETFs different from regular mutual funds?
We cannot trade mutual funds like stocks, but we can trade ETFs just like stocks. ETFs can be traded in secondary markets, unlike mutual funds. Thus, ETFs can be traded throughout the day and also during extended trading hours, but mutual funds can only be traded once during a day. Mutual funds are actively managed funds that require a portfolio manager to update their holdings to try and outperform the market constantly. On the other hand, ETFs are mostly passively managed funds that work on the buy-and-hold proposition. There are also ETFs that are actively managed like mutual funds, and the portfolio manager takes decisions about which stock to buy, sell, or hold. These actively managed funds usually have a higher expense ratio than a passively managed fund.
ETFs are more tax-efficient than mutual funds. Due to the mutual funds having a larger turnover in relation to an ETF, mutual funds have higher capital gains.
How are ETFs traded like stocks?
ETFs are passively managed like stocks. An ETF matches a particular market index, and the portfolio manager only needs to make minor, periodic changes to keep the fund in line with the index. The managers are not required to manage the investors’ funds and take decisions about buying, selling, or holding the stocks, but just to oversee that the returns from the fund mimic the returns of the benchmark index. ETFs trade at a discount or a premium of the NAV of the underlying assets.
One of the major differences between stocks and ETFs is that stocks are usually of a single company, whereas ETFs are a basket of stocks of different companies, thus allowing for diversification and reducing the portfolio’s risk. Being related to a particular market index, ETFs mostly cover a discrete number of stocks, whereas stocks, in general, can be traded as fractional shares. Hence, ETFs mitigate managerial risk. Having mentioned the same, it means that when the value of one investment in one of the securities in the ETF goes down, the other securities held in the fund helps to stabilise the return. This means the performance of the overall portfolio is less affected by the market prices of the individual securities taken into consideration.