Mutual funds and ETFs are two popular investment vehicles among the new generation of inventors. They both pool money from multiple investors to invest in a basket of securities. But despite the similarities on the surface, they have different characteristics, advantages, and disadvantages. This article about ETF vs mutual funds provides a concise and comparable understanding of both investment options, enabling informed decision-making.
What Are Mutual Funds?
Mutual funds are a type of investment that pools money from multiple investors to invest in a diversified portfolio. The investors are allotted units based on the fund’s NAV, which is the per-share value, calculated by dividing the total asset value of the fund by the total number of outstanding units. The NAV of the fund keeps changing on a daily basis.
Professional fund managers manage the scheme and spread the money across securities, including equities, bonds, and money and cash market instruments. It offers instant diversification, while the fund’s holdings help mitigate risks.
Read More About What is Mutual Fund?
What Are Exchange-Traded Funds (ETFs)?
ETFs combine the best characteristics of mutual funds and individual equity investments. ETFs allow investors to invest in a bouquet of securities while offering the ease of trading ETFs like stocks on stock exchanges. ETFs offer investors exposure to a diversified portfolio of underlying assets, such as stocks, bonds, or commodities, without the need to hold them directly.
ETFs invest following the principle of passive investment. They track the performance of a sector, commodity, index, or asset to generate similar returns.
Here it is important to note that ETFs are quite similar to index funds as they both invest following a market index, but they are not the same. In an index fund, the fund manager creates a portfolio that mimics the index it follows. So, if the index contains 50 stocks, then the fund will also contain 50 stocks. ETFs, on the other hand, can contain only a fraction of the shares. For example, if the ETF is 1/100 of the index and the index is 1500, then the value of one ETF unit is Rs. 15.00.
ETFs vs Mutual Funds
After understanding the fundamentals of mutual funds and ETFs, let’s now discuss the differences between ETFs and mutual funds.
Parameters | Mutual Funds | ETFs |
Definition | Mutual funds pool money from multiple investors to invest in a diversified portfolio | ETFs also invest in a basket of securities like mutual funds but these can be traded on the exchange like stocks |
Fund management | These can be actively or passively managed | Generally passively managed |
Value at redemption | The redemption value depends on the calculated NAV of the day | ETF units can be bought or sold at any time at the prevailing market rate |
Lock in | Mutual funds don’t have lock-ins usually, but there can be exit charges if you redeem before a specific period | Usually don’t have lock-in periods |
Charges | Actively managed mutual funds can have expense ratio as high as 2% | The expense ratio of ETFs can be as low as 0.35% |
Valuation | Mutual funds don’t trade in the stock exchange and the NAV is calculated only once at the end of the day | ETFs are traded like stocks and their price fluctuates with the ups and downs in the market |
Similarities Between Mutual Funds and ETFs
Knowing the commonalities between ETFs and mutual funds will help you make an informed choice.
Diversification: Mutual funds and ETFs, both, invest in a basket of underlying securities. So that during adverse market conditions, the returns are not badly impacted.
Passive investment: Both follow passive investment strategies, wherein the investment portfolio invests in the same securities in the same proportion as the index it tracks.
Professionally managed: Fund managers are responsible for taking investment calls. The fund’s performance depends on the experience of the fund manager.
NAV: Both derive value from the underlying asset. In both cases, the NAV is calculated to measure the fund’s performance.
How to Redeem: Mutual Funds vs ETFs
If you are redeeming mutual fund units offline, you must submit a duly signed redemption form to the AMC. You must fill in all details, such as the holder’s name, folio number, and number of units to redeem.
If you are redeeming online through the Angel One platform, log in to your account and choose the fund and number of units you want to dilute.
You can calculate the amount you will receive by multiplying the number of units you want to redeem by the current NAV value. For instance, if you redeem 200 units of a fund and the current NAV is Rs. 80.56 per unit, the total amount you will receive is Rs. 16,116.
The redemption and creation of ETFs are not limited to those of mutual funds. The number of units increases when the investor deposits shares to create ETF units. Similarly, when the investor redeems units, the number of shares decreases. ETF units are continuously created and redeployed as investors buy and sell them during the day on the exchange. If the NAV of the underlying securities of the ETF is higher than the index, the investor may redeem the units to the Sponsor (the company that issued the ETF) for a profit.
Read more about Mutual Fund Redemption
ETF or Mutual Fund: Which Is Right for You?
Deciding to invest in ETFs or mutual funds depends on individual preferences and investment goals. ETFs offer flexibility, low costs, and real-time trading on exchanges, making them suitable for active traders and those seeking specific market exposure. Mutual funds offer investors exposure to a professionally managed, diversified portfolio with reinvestment options, making them suitable for long-term wealth creation.
While investing in either an ETF or mutual fund, you must consider the following parameters.
- Investment strategy
- Risk tolerance
- Liquidity needs
- Fees
You must consult a financial advisor who can assess your unique circumstances and help determine which investment vehicle aligns best with your objectives.
Final words
Mutual funds and ETFs, both, need careful consideration with respect to your investment goals, objectives, and liquidity needs. ETFs are suitable if you seek active participation in the stock market. These are highly liquid and can be used for short-term gains. Mutual funds are more suitable for generating long-term returns. However, consult your financial advisor before making a decision.
FAQs
Which is a better investment: mutual funds or ETFs?
Investment is a personal decision taken based on your investment requirements, risk tolerance, and long and short-term financial goals. ETFs are more suitable for active investors who want to capitalise on the changing ETF NAV values. Mutual funds, on the other hand, help with long-term capital generation.
Which is riskier: mutual funds or ETFs?
ETFs usually carry more risks because they are traded on an exchange. The value of the ETF changes with the changes in index value, meaning if the market dips, the price of the ETF will also decline in a short period of time.
How are ETFs taxed in India?
Tax on ETFs depends on the type of income and the nature of the underlying asset.
Dividend income tax – Income from dividends is taxed as per the investor’s income tax slab rate.
Capital gain tax – In the case of capital gains, the taxation is different for equity and other ETFs, as follows:
- On equity
- For equity ETFs short-term capital gains for a holding period of less than one year, a 15% flat tax rate is applied.
- For long-term gains for a holding of more than 12 months, a 10% tax applies on capital gains generated over Rs. 1 lakh. No indexation benefits are offered.
- On debt, gold, and other ETFs
- The short-term capital gain for a holding period of less than 3 years is taxed as per the income tax slab rate of the investor.
- For a holding period of more than 3 years, long-term capital gain tax is 20% with indexation.
What is the minimum investment amount for ETFs?
There is no minimum investment amount. The minimum amount will depend on the price of the ETF plus any commissions and charges.
Where can I buy ETFs?
ETFs trade in the stock market like stocks. You can place a purchase request through your broker.