Mutual funds vs ETFs: Know the difference

Mutual funds and Exchange Traded Funds are similar in many ways, causing much confusion among investors, particularly those who are new to the stock market.

Let us first try and define the two instruments before going into their pros and cons.

Mutual funds:

These are investment schemes handled by professional fund managers who invest funds from various investors in diversified holdings including stocks, bonds and debt instruments and indexes to name just a few. The net asset value or NAV of each fund or scheme is derived by dividing the total investment of a mutual fund by the number of units issued. The fund manager invests a lot of time and experience in ensuring that the individual investor gets the best possible returns for his money based on a fund’s investment objective and risk taken.

Exchange Traded Fund:

An ETF, on the other hand, is a fund that mirrors or replicates an index like the Sensex or Nifty, and holds stocks in the same ratio as the underlying index, or assets – Gold ETFs for instance. Since ETFs don’t need active fund management because they just mirror the index or asset, they have far lower fund management expenses. ETFs are actively traded on stock exchanges and can be purchased and sold throughout the trading day. So, when you buy units in ETF, their value goes up or down corresponding with the value of that index.

Pros & Cons:

Flexibility:

An ETF trades like a regular stock, but similar to mutual funds, you can use ETFs to invest in a broad variety of instruments including stocks, commodities and bonds. You can trade in ETF during market hours at real time market prices, giving you a lot of flexibility. To buy or sell a mutual fund, however, you need to place an order with the fund house, and the net asset value or NAV is the price of each unit of a mutual fund, which can keep fluctuating daily.

Transaction costs:

Although ETFs have lower operating fees and expenses than even index funds, you need to keep an eye out for transaction costs. Since they are traded freely on the exchange, you will need to pay brokerage and taxes for each transaction you make. Mutual funds, however, can be transacted without paying brokerage charges.  

Investment style:

While most mutual funds are actively managed and try to outperform the market, ETFs are passively managed. So, if you are looking forward to higher then market returns by taking higher risk, mutual funds are a good product for you.

Liquidity:

Since mutual funds are not connected to daily trading volumes, they are considerably more liquid, as compared to ETFs. The liquidity associated with ETFs is linked to the stock market volumes and varies from fund to fund.

Conclusion:

ETFs are quite popular in developed countries and consistently beating mutual funds. But in emerging economies, due to high growth potential, mutual funds have performed better than ETF. If you are looking for a passively managed fund with low to moderate risk, ETFs can be a good choice. If you are willing to take a higher risk to earn better than market returns, mutual funds will give you good options.

Disclaimer: The contents herein mentioned are solely for informational purpose and shall not be considered as an invitation or persuasion to trade or invest. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon.