Portfolio Diversification is a key strategy to manage risk in the securities market. ETFs and Mutual Funds are those instruments that inherently offer diversified portfolios. ETFs and Mutual Funds have lots in common. But they differ in how they are traded, managed, and taxed. Let’s compare ETF and Mutual Funds and see what is in common and what is different.
What are Mutual Funds?
Mutual funds are professionally managed investment schemes that pool money from various investors and invest it in a wide range of securities such as stocks, bonds, debt instruments, etc. If you are buying a mutual fund unit, you are purchasing a portfolio of securities in a minuscule fraction of the whole.
Each scheme has a defined Net Asset Value (NAV) which is derived by dividing the total investment of a mutual fund by the total number of units.
What is an ETF?
Exchange-Traded Funds, commonly known as ETFs are investment instruments that pool funds from various investors to invest in various assets that can be traded on an exchange. Hence, the name Exchange Traded Funds. ETFs have a combination of the diversified portfolio feature of Mutual Funds and trading on exchange features of exchange-traded securities.
An ETF usually copies an index, which means that it usually consists of stocks of different companies in the same proportion as present in the particular index.
Developed in the mid-90s, ETFs are younger than mutual funds but have grown into popular investment instruments in recent years.
Similarities between ETFs and MFs
Fund Pooling
Both ETFs and Mutual Funds collect money from a group of investors and pool the funds to invest in a basket of securities.
Diversification
Both instruments invest in varied assets providing diversification and risk mitigation.
NAV
Both derive their value from the underlying assets they invest in, and the net asset value is calculated.
Differences between ETFs and MFs
| Factors | Mutual Funds | ETFs |
| Buy and Sell method | Mutual Fund units can be bought or sold only from the fund house.
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ETFs can be freely traded on an exchange just like exchange-traded securities and can be bought and sold at the investor’s convenience. |
| Pricing | Net Asset Value (NAV) indicates the price of a unit of a mutual fund and it is set once a day after the market is closed. | For most ETFs, the market price is usually available in real-time just like ordinary equity shares. |
| Management( Active/Passive) | Mutual Funds are generally actively managed as fund managers, backed by analysts who pick and choose investments, on behalf of investors.
You can find passively managed Mutual Funds too |
As ETFs merely replicate the performance of an index, they can be passively managed.
However, there are actively managed ETFs too. |
| Expense Ratio | High | Low |
| Brokerage | No | Yes (Depending on the terms of broker) |
| Lock-in Period | Mutual funds like ELSS (Equity Linked Savings Scheme) come with a lock-in period of 3 years. | ETFs do not have a minimum holding period, and the investors are free to sell the investment as and when they like |
| Exit load | Many Mutual Fund schemes charge exit load if MF is redeemed before the minimum holding period | No exit load as ETFs are traded on exchanges in real-time |
| Systematic Investment | Available through Fund House | Only a few broker platforms have started providing SIPs in ETFs |
Both ETFs and Mutual Funds offer an excellent opportunity to build a diversified investment portfolio. As your investment choice depends on your financial goals, risk appetite, tax-saving strategy, liquidity ratio, and other factors, choose an investment instrument that fits your needs. Also, remember that the security instruments are subject to market risks and make sure you read all scheme-related documents carefully before investing. Happy investing, folks!!
