ETF vs Mutual Funds

What are Exchange Traded Funds?

Exchange Traded Funds, or ETFs, are one of the several options available to investors in our investment universe. They are structured like a fund and help invest across several asset classes. In the Indian context, equity ETFs are in prime focus, though they can potentially provide access to fixed income, currency, and commodity asset classes as well. Gold ETFs follow equity ETFs in terms of popularity in India, and bond ETFs and theme-based ETFs have also seen the light of day in recent years.

The key feature of ETFs is that they track an index which forms the investment basket for the fund. Its portfolio comprises of the same securities in the same proportion as that of the index. In this way, ETFs can be understood to be passive investment vehicles. Their portfolio composition changes only when the underlying index is rebalanced. This can happen periodically like quarterly, half-yearly or yearly.

The ownership unit of an ETF is known as a share. Apart from tracking an index, another key feature of ETFs is that they are listed on stock exchanges. Because of this, they can be traded like stocks throughout the trading day. Their price fluctuates like that of individual stocks. Similar to fund structures, an end-of-day Net Asset Value (NAV) is also calculated for ETFs.

An important metric for investors to measure the efficiency of an ETF is the tracking error. The thumb rule regarding this is, ‘the lower the tracking error, the more efficient the ETF.’ This is so because a lower tracking error indicates how closely the performance of an ETF mimics that of its underlying index.

Also, ETFs tend to be cheaper than conventional fund structures as they do not require a portfolio manager or analysts to construct, monitor, and make changes to the portfolio.

What are Mutual Funds?

Mutual funds are investment pools, created by contributing investors, which are invested in accordance with pre-decided investment objectives. Similar to ETFs, they provide exposure to various asset classes to an investor. Mutual funds which help investors invest across multiple asset classes via a single fund are also available.

In exchange for their money, investors receive units or shares in a mutual fund. An expert investment team is appointed to manage a fund’s portfolio. They are responsible for its performance and ensuring that it meets its investment objectives.

Mutual funds declare an index as their performance benchmark. However, they are not required to necessarily replicate their portfolio. Their intention is to perform better than the benchmark for which the portfolio management team charges a fee.

Mutual funds help investors diversify their investments across asset classes and within asset classes as well. This helps investors reduce the risk they would otherwise incur if they were to invest in individual stocks and bonds. Further, investors get the benefit of professional management as well. The investment team appointed to manage a fund has years of professional experience in managing money and executing investment strategies. Their expertise is available to investors once they invest in a fund.

Similarities between ETFs and Mutual Funds

Before looking at the differences, let’s first look at how these two fund vehicles are similar. Both are baskets of securities and are transparent in nature. An investor can get to know where his money is invested at any point of time because of mandated periodic disclosures. This information is not restricted only to the asset class level, i.e. the proportion of stocks, bonds, and cash equivalents. It percolates down to the level of sectors and individual securities as well. The same if the case if the fund invests overseas.

Investors can also assess performance as both types of funds are required to declare the price data at the end of each trading day. They also provide a periodic performance comparison between that of the fund and the benchmark.

Both fund structures offer two types of appreciation – capital gains accumulated over the period of investment, and dividend distributions.

Lastly, shares or units in both types of funds can be created and redeemed on demand without any cap.

Differences between Exchange Traded Funds and Mutual Funds

In the Indian investment universe, ETFs are passive investment vehicles which help investors invest according to the composition of the underlying index of a fund. On the other hand, mutual funds are actively managed for the most part. Being actively managed means that there is a portfolio manager who creates and monitors the investment portfolio and makes changes when he deems fit. The passive form that mutual funds adopt is known as index funds.

Since mutual funds employ the services of an investment team, they tend to be more expensive than ETFs which do not require professional management.

Because of being listed on stock exchanges, ETFs provide trading on a continuous basis throughout the trading day. On the other hand, though orders for mutual funds can be placed at any time of the day, they are executed on either the same day’s NAV or the next day’s NAV based whether the order was placed before or after the cut-off timing for a particular category of mutual funds. On a similar point, in terms of price, mutual funds can be traded only on their end-of-day NAVs while ETFs can be traded on different price levels which change throughout the day.

Further, since retail investors can buy ETFs only via exchanges, they need a brokerage account without which they would be unable to transact in them. This is not the case for mutual funds which can be bought or sold directly from fund houses, via distributors or advisors, and even online without the need for a brokerage account.

Since ETFs allow for continuous trading and are available only via a trading platform, they offer much higher liquidity than mutual funds. This means that if one needs funds on an urgent basis, one can sell ETFs right then while for mutual funds one would need to place the order, wait for it to get executed at the applicable NAV and then wait a bit more for the proceeds to be transferred to one’s bank account. If the redemption in a mutual fund is via cheques, it would take a few more days for the redemption amount to be credited to a bank account.

The chief differences between ETFs and mutual funds can be summarized in the table below: