Exchange-traded funds or ETFs have recently gained popularity as they come with lower expense ratios and are a lot easier to understand. Like mutual funds, ETFs also pool money from investors to invest in a portfolio of stock, bonds, and other financial securities. So how exactly are ETF and mutual funds different?
The most important point of differentiation between these financial products is that ETFs are traded on the stock exchange just like stocks. ETFs can be bought and sold at the prevailing market price that the forces of demand and supply would determine. To invest in ETFs, one must have a demat account.
On the contrary, mutual funds are not traded on an exchange. The purchase price is determined by the value of the portfolio of assets held in a mutual fund and is also known as Net Asset Value or NAV. Mutual funds can be purchased directly from the asset management company that is running the scheme, and thus, there is no requirement for having a demat account.
Another important difference between a mutual fund (other than index funds) and an ETF is that ETFs are passively managed funds. The portfolio of an ETF is created to replicate the portfolio of an index. Thus a fund manager does not have to use his skill or judgment to choose securities for the portfolio. Due to this reason, ETFs have a much lower expense ratio as compared to mutual funds.
There are different types of Exchange Traded Funds (ETFs):
Equity ETF: These ETFs replicate or mirror equity indices such as the Sensex or the Nifty50.
Debt ETF: These ETFs replicate or mirror bond market indices such as CRISIL 10 Year Gilt Index or the CRISIL AAA Short Term Bond Index.
Gold ETF: These are commodity exchange-traded funds that invest in physical gold assets. In this way, investors can own gold without having to be worried about storage costs.
Currency ETFs: These ETFs have the objective to profit from currency movement. The currencies of different countries are purchased based on the future expected currency projections.
Difference between Mutual Fund v/s ETF:
|Liquidity||One can purchase and redeem mutual funds at any point of time in open-ended mutual funds.
|ETFs are close-ended mutual funds. Thus, there are no additional purchases or redemptions once the funds are raised, and the portfolio of assets is created that mirrors an index. The demand in the market determines the liquidity in an ETF.|
|Management||Skilled and professional fund managers actively manage mutual funds other than index funds. Fund managers create a portfolio of well-researched securities to maximize returns for investors.||ETFs are passively managed funds that mirror or replicate the portfolio of the index it tracks. The fund manager does not have to apply his judgment in choosing the stocks.|
|Expense Ratio||Mutual fund expense ratios can go upto 2%. These expenses are deducted from the returns generated by the fund’s assets.||ETFs have a major competitive advantage of lower expense ratio which could be as low as 0.35%. This is because ETFs are passively managed.|
|Flexibility||One can invest in mutual funds through two modes: Lump Sum and Systematic Investment Plans (SIPs). Thus, one can invest in small regular amounts on intervals of weekly, fortnightly, monthly, and quarterly based on the investor’s convenience.||ETFs do not provide the investors the option of SIPs.|
|Purchase price||Mutual funds are traded at closing net asset value.||The purchase price is determined by the price prevailing on the stock exchange then.|
|Buying and Selling method||Mutual funds need to be purchased from the respective asset management company.||The units of the ETF are traded on the stock exchange.|
After understanding the difference between an ETF and mutual fund, it is clear that ETFs may be useful for investors who wish to have concentrated exposure to a specific asset class, sector, region, or currency. Investors need not be concerned about researching what the best avenue to invest is. For investors with a long-term investment horizon, a low expense ratio offered by ETFs allows investors to make better returns after expenses. Since ETFs are not actively managed, they are free from the behavioral biases of the fund manager.
Investors must consider their liquidity needs, investment horizon, return expectations, and risk appetite when deciding between ETFs and mutual funds. Since ETFs are market-linked products, they ought to be more volatile. Equity-based products will be more volatile than debt. Also, if an investor does not wish to open a demat account, they might find it convenient to invest in mutual funds. On the other hand, mutual funds can help create alpha for investors by careful stock picking and the skill to identify opportunities.
It may be essential to note that ETFs aim to track an index and not to outperform or beat the underlying. Hence, it may not be able to earn returns that beat the market. Thus, if the investor can outperform the market, actively managed mutual funds are a better choice for the investors. Especially for investing in mid and small-cap companies, active management strategies are required to identify untapped opportunities in this space. Since the large-cap universe is limited to the top 100 companies listed on the exchange, investors may find it beneficial to invest in Large-cap ETFs and benefit from lower expenses.
However, if an investor wants to get exposure to financial markets without opening a demat account, mutual funds would be a good investment vehicle. Investors can make a well-informed decision after careful consideration of their goals and objectives.