Mutual Funds vs ETFs: What Are the Differences?

Mutual funds (MFs) and Exchange Traded Funds (ETFs) are two investment options that appear similar, but to find the most suitable choice, you must know the differences between mutual funds and ETFs. 

Mutual funds offer more options with active management and high operational costs, while ETFs are a low-cost and flexible option. The following sections will tell you the features of both these investment options and help you select the right option for your financial goals.

What Is a Mutual Fund? 

A mutual fund pools money from various investors sharing common investment goals. Fund managers manage the operations of mutual funds, and they invest the pooled money in bonds, stocks, money market instruments or other asset classes. 

MFs are offered by fund houses and managed by fund managers who invest in a variety of assets as per the scheme’s objectives. A mutual fund scheme is managed in such a way that it can generate lucrative gains for each investor while taking some calculated risks. So, once you, as an investor, buy a unit of the MF investment scheme, you actually purchase a small portion of the underlying portfolio of stocks, bonds or other securities. The NAV, which is calculated on a daily basis, represents the market value of the fund’s assets, and the performance of those assets decides the returns you will generate on your investment.

The gains or losses generated from this cumulative investment are later distributed among the investors after deducting certain expenses. Investors purchase units of a mutual fund that represent their holdings. Buying and selling of fund units take place at the prevailing NAV (Net Asset Value).

What Is an Exchange Traded Fund (ETF)? 

An Exchange Traded Fund (ETF) is a tradable security that is passively managed and replicates the portfolio and performance of a publically available index. Like an MF, ETFs also invest in stocks, bonds and other assets and are bought and sold in units. However, unlike mutual funds, these are listed securities and can be traded only on the stock exchanges via registered brokers.

In an ETF, investors can buy as many units as they wish via the exchange. The NAV of ETF units varies according to market movements. ETFs track indexes like BSE Sensex, CNX Nifty, Hang Seng Index, or S&P 500. Like stocks, you can trade ETFs during market hours on stock exchanges.

When you buy ETFs, you buy units/shares of a particular portfolio, which tracks the return or yield of a certain index. Unlike actively managed investments, an ETF does not attempt to outperform its corresponding benchmark index but instead replicates its performance. Another profitable feature is that a typical ETF scheme has lower fees than a mutual fund, which often makes it an ideal choice for independent investors.

Advantages of Investing in ETFs and Mutual Funds

ETFs

Here is a list of some key advantages of ETFs:

• Diversification – An ETF provides exposure to a diversified portfolio of securities or assets.
• Tax benefits – An individual can invest with higher tax efficiency by investing in the CPSE (Central Public Sector Enterprises) ETFs. These ETFs allow tax deductions of up to Rs. 1.5 lakh under Section 80C of the IT Act.
• Less volatility and less risk – ETFs are less volatile than many actively-managed MFs, as they emulate an index’s performance. 
• Low administrative costs – Because an ETF is passively managed, the administrative costs incurred are comparatively lower than those of actively managed MFs. For an ETF, the management cost is as low as 0.20% p.a. compared to 0.5% to 1% p.a. for some MF schemes.  That is why EFTs have a lower expense ratio compared to normal MFs.

Also Read: Index Fund vs. ETFs: What’s the Difference?

Mutual Funds

Here’s a list of key advantages of MFs:

• Expert and professional management – If you do not have the time or experience to analyse the market, then you can count on your fund manager’s experience and expertise. The fund manager makes informed decisions depending on the investment objectives, assuring you the best returns.
• Tax-efficient – If you invest in “tax-saving mutual funds” like ELSS, you will qualify for a tax deduction as per Section 80C of the IT Act, 1961. A maximum amount of Rs. 1.5 lakh p.a. can be deducted from your taxable income. ELSS also invests in stocks across sectors giving you a diversification advantage.
• Investing in small denominations – You may invest in small denominations (Rs. 500) through SIPs. This can help reduce average investment costs.
• Suits financial objectives – There is a huge diversity in the types of MFs in India. This makes it relatively easy for you to choose and select a mutual fund as per your time horizon, income, risk appetite and financial objective.
• Better Returns with Actively Managed Funds: Certain mutual funds are actively managed by the fund managers, that is, the fund manager can use their discretion in deciding the investment portfolio of the fund. There is a possibility of earning better returns with such mutual funds.

Disadvantages of Investing in MFs and ETFs

ETFs

Here’s a list of the disadvantages of ETFs.

• Limited diversification – Investors may miss out on stock-specific opportunities as ETFs emulate the index returns. All stocks are not covered in an index and investors will not be able to invest in a particular stock by investing in ETFs. You might miss some growth opportunities due to this limitation.    
• Fall in dividend yield – Even though a dividend-paying ETF offers lower risk, the yields are often not high compared to the yield of stock dividends. This is because an ETF tracks a bigger market, and thus, the total yield is less.

Mutual Funds

There are a few disadvantages offered by mutual funds, as discussed below.

• Exit load – When you plan to exit a mutual fund early, you need to pay exit loads as fees charged by the Asset-Management-Companies (AMCs). This discourages the investors from redeeming their investments till a certain period and helps the fund managers accumulate the required amount for purchasing the required securities.
• Management cost – This refers to the expense ratio, a charge levied for the fees of fund managers, market analysts and operational costs, and it is borne by the investor. The total charges incurred due to the management of active funds need to be considered when you choose a mutual fund scheme. A high expense ratio will impact your total returns negatively. 

Differences between Mutual Funds and ETFs

Before making an investment decision, you need to know the basic difference between MF and ETF.

The table below draws a detailed comparison between these investment options.

Parameters You Need to Consider Before Investing

Even though both mutual funds and ETFs will help you build a diversified portfolio, there are also certain differences between ETFs and mutual funds. So, before you invest, you need to understand the key factors thoroughly and invest according to your financial planning. 

Let’s check out these factors.

• Your investment objective – You need to consider three objectives before deciding on an investment option: capital gain, safety and income. ETFs are passively managed and comparatively safer than actively managed MFs. On the other hand, many mutual funds offer better capital gains than ETFs. 
• Your risk appetite – Risk appetite refers to your ability to tolerate investment risk and/or loss associated with it. Being an actively managed fund, most mutual funds carry more risks than ETFs.
• Investment liquidity – ETFs can be bought and sold on exchanges. However, you need to wait for a while when redeeming mutual fund units.
• Time horizon – Time horizon refers to the time frame you wish to remain invested in. Choose the investment option that fits you well based on your time horizon.  

Final Word 

Your financial objective, risk appetite, age, time horizon of investment, inclination towards long-term investment or short-term gains, liquidity of assets, tax saving approach, etc. all come into play when you choose between an ETF or MF investment scheme. You need to understand the differences between an ETF and Mutual fund to make an informed investment decision. The widely ambiguous market scenario of the modern world demands that you remain well-informed on the difference between an ETF and mutual funds to always stay one step ahead!

Frequently Asked Questions