ETF vs Mutual Fund – Similarities and Difference Between ETF and Mutual Fund

  Investment is as essential for any person as earnings. It is an assured way of securing a person’s future especially when they are no longer in a position to earn a regular income. There are many types of investment options available in the market today other than the traditional options like LICs, PPF, Fixed Deposits, etc. Today investment in the stock market is quite favored especially by the younger population as the possibility of returns is quite high. Investment in stock markets has many safer options like mutual funds, index funds, ETFs, and much more. ETFs and mutual funds have many similarities but are essentially different investment products. The details of the same are discussed below.

What is an ETF?

ETF is the abbreviation used for Exchange Traded Fund. It is a type of investment where the investor gets the benefit of investing in multiple securities under a single fund. ETF is a pool of multiple securities usually in the same composition as the underlying index that it tracks. This reduces the risk involved in such investment as the product has diverse securities as well as the sole intention to replicate the index performance.

What is a Mutual Fund?

Mutual Funds are also a very popular investment product. These funds are also a pool of securities, debts, bonds, and many more assets that can be invested through structured Asset Management Companies (AMCs). These funds are also relatively safer investment options as compared to individual stocks due to their diversification and lower expenses related to the investment. 

Similarities between ETF and Mutual Fund

ETFs and Mutual Funds are both a cluster of individual securities. Although they are essentially different products, they have many similarities. Some of such similarities are discussed below.

• Diversification

ETFs and Mutual Funds are composed of many securities or assets that determine the overall performance of the fund. Securities under an ETF are formed based on the index that it tracks (usually in the same weights as the securities on the index), securities under a Mutual Fund are carefully selected by the fund manager after thorough market analysis to achieve maximum returns. 

• Professionally managed assets

ETFs and Mutual Funds are both professionally managed assets. While ETFs are passively managed assets and do not require a dedicated team of fund managers, Mutual Funds are actively managed funds and require a team of dedicated fund managers to achieve the maximum return on investment of investors.

• Reduced risk

ETFs and Mutual Funds are diverse funds that have multiple assets. If one asset or security in the fund performs poorly and the other performs better, it will reduce the overall risk of the fund thereby protecting the investor’s investment.

Difference between ETFs and Mutual Funds

As discussed above, ETFs and Mutual Funds are similar investment products. However, there are certain basic differences between them. These differences are highlighted below. 

• Cost

The cost of managing an ETF is quite low as they are not actively managed funds, hence, the cost or the expense ratio for an ETF is quite low as compared to a Mutual Fund.

• Tax benefit

Depending upon the asset class tracked by ETF, Long or Short term capital gains are to be paid. The categorisation and the rate of taxation are based on the major assets tracked by the ETF, it could be equity or debt funds. 

• Portfolio management

ETFs are passively managed funds as they merely track the underlying index and reduce the deviations known as tracking errors to the maximum extent possible. Mutual Funds are actively managed funds that are constantly reviewed and managed by fund managers with the aim to maximize the returns for an investor.

• Trading

ETFs can be traded in the open market during market hours just like individual stocks. They also have the benefit of intraday trading, unlike Mutual Funds. Mutual Funds can be traded only at the end of the day based on the closing price or the NAV which is declared to the AMC.

• Returns to investor

As mentioned above, an ETF merely tracks the underlying index so the returns are similar to that of the index performance. Mutual Funds are carefully curated funds based on a thorough analysis of the market that strive to outperform the market or give higher returns to the investors.

• Liquidity

Mutual funds have an exit load of 1% if the investor redeems more than 10% of the units within 12 months from the date of the initial investment. ETFs have no such condition and the investor can exit the fund at any time, and thus the fund has high liquidity as compared to a Mutual Fund. 

• Limit orders

Limit orders are a facility available in the case of ETFs where the investor can execute a trade at a preselected price when such price level is reached in the market. Mutual Funds are not traded during the market hours and hence do not have the benefit of limit order trading. 

• Composition of the fund

ETFs are composed of securities or assets in the same composition or weightage as the index that it tracks. Mutual Funds on the other hand are formed based on the careful consideration and analysis of fund managers to achieve maximum returns for the investors. ETFs and Mutual Funds are an excellent option when the investor wants to have a diversified investment. These investments provide the investor an opportunity to be able to reap the benefits of investing in the share market at the same time reduce their costs to make the most of their investments. 

Conclusion 

ETFs and Mutual Funds are different investment products and selecting one over the other for investment depends on many factors like the risk appetite of the investor, period of investment, etc. If the investor is looking for a high-risk high-return scenario, mutual funds seem a better option but for a risk-averse investor, an ETF is an ideal option.

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Frequently Asked Questions

Is ETF a safer investment option than Mutual Funds? Yes. ETFs simply try to replicate the performance of the underlying index while minimizing the tracking errors at the same time. But actively managed mutual fund managers may assume a higher risk to generate better returns.  Hence, ETFs may be a safer investment option compared to Mutual Funds.

Why is the expense ratio higher in the case of mutual funds than ETFs?Mutual Funds are actively managed funds and require a dedicated team of expert fund managers that handpick the assets in the fund to achieve maximum returns for the investor. Hence, the expense ratio is higher in the case of mutual funds than ETFs. Are ETFs considered to be more liquid funds than Mutual Funds? Yes. An investor can exit from the ETF at any point. There are no restrictions like exit load which are usually part of mutual funds. Hence, ETFs are considered to be more liquid than Mutual Funds. Can ETFs be traded in the open market? Yes. ETFs can be traded in the open market like any individual stock or share. This is the fundamental difference between ETFs and Mutual Funds. Can a person invest in ETFs as well as Mutual Funds? Yes. ETFs and Mutual Funds are excellent investment options and will provide higher diversity in an investor’s portfolio thereby increasing the chances of higher returns.