What is the Difference Between ETF and Mutual Fund

As the Indian investment landscape evolves, the choice between Exchange-traded Funds (ETFs) and mutual funds becomes increasingly pertinent for investors. According to the Association of Mutual Funds in India (AMFI), mutual fund investments in the country soared to an impressive Rs. 50 trillion (Rs. 50 lakh crore) as of December 2023. 

In the same vein, although a relatively smaller segment, ETFs have carved out a significant niche, accounting for nearly 13% market share. This shift in investment trends brings to the forefront the crucial question: what is the difference between an ETF and a mutual fund, and how does this impact your investment strategy? In this guide, we delve into these nuances to help you navigate the complex yet rewarding world of investments in India.

Mutual Fund vs. ETF: An Overview

At their core, both mutual funds and ETFs are investment vehicles, pooling money from various investors to purchase a collection of securities like stocks, bonds, or other assets. However, the way they are managed and traded marks the primary difference between ETFs and mutual funds.

Mutual Funds

Here is an overview of mutual funds:

•    Professionally Managed: Mutual funds pool money from investors and hand it to experienced fund managers who actively choose and manage the fund's investments.

•    Transparent Pricing: The value of your mutual fund holding is based on its Net Asset Value (NAV), calculated daily and reflecting the fund's total assets minus liabilities, divided by outstanding shares.

•    Easy Transactions: You buy or redeem mutual fund units directly at the NAV price, making the process simple but limited to trading once a day.

•    Expert Guidance: A key advantage of mutual funds is the expertise of the fund manager who actively buys and sells securities within the fund, aiming to outperform the market for investors who prefer professional guidance.

Exchange-traded Funds

Here is an overview of the ETFs:

•    Modern and Flexible: ETFs offer a modern approach, traded on stock exchanges like individual stocks.
•    Real-Time Trading: Buy and sell ETFs throughout the trading day at fluctuating market prices.
•    Increased Liquidity: This trading flexibility allows for quicker reactions to market changes.
•    Passive Management: Many Indian ETFs are passively managed, tracking an index (like Nifty 50) or sector, leading to lower fees. 

Key Differences Between ETF and Mutual Fund

Understanding the differences between ETF and mutual funds is crucial for investors. The following table highlights the key distinctions between these two popular investment options, offering insight into the differences between ETF and mutual funds and how they cater to diverse investment strategies.
 

Parameter	ETFs	Mutual Funds
Trading	Traded like stocks, can be bought and sold throughout the trading day.	Bought and sold based on their Net Asset Value (NAV) at the end of the trading day.
Management Style	Typically, passively managed, tracking a specific index or sector.	Often, it is actively managed by fund managers making investment decisions.
Expense Ratios	Generally lower due to passive management.	Higher, especially for actively managed funds, due to management and operational costs.
Minimum Investment	As low as the price of one unit.	You can start with Rs. 500 through the SIP route.
Liquidity	High liquidity; can be traded any time during market hours.	Liquidity at the end of the trading day when NAV is calculated.
Investment Approach	Focus on tracking market indices or sectors.	Aim to outperform the market or a benchmark index.
Dividend Reinvestment	Dividends are usually paid directly to investors.	Option for automatic reinvestment of dividends into additional fund shares.
Transparency	Holdings are typically disclosed daily.	Holdings are usually disclosed monthly or quarterly.
Market Impact	Lower market impact costs due to in-kind purchases and redemptions.	Potentially higher market impact costs when buying or selling large volumes of securities.

ETF or Mutual Fund: Which is the Best for You?

If you are keen on building a well-rounded investment portfolio, both of these options can serve you well.

•    However, as mentioned earlier, your choice should depend on factors like the time horizon, risk tolerance, and financial objectives.
•    Some investors may prioritize liquid investments over long-term ones.
•    Despite the similarities in the nature of these funds, a smart combination of ETFs and mutual funds can enhance the performance of your investment portfolio.
•    Before taking any action, it's crucial to grasp how both funds function, evaluate the market risks you're comfortable with, and seek advice from a professional to ensure you're making the right investment decision.

Are ETFs Riskier Than Mutual Funds?

While ETFs and mutual funds can be built differently, the underlying investments they hold are what truly determine the risk. Both ETFs and mutual funds can offer:

•    Diversification: They can hold a basket of stocks, bonds, or other assets, spreading your risk across multiple investments.
•    Variety: There are ETFs and mutual funds for all sorts of investment strategies, from low-risk bond funds to high-growth stock funds.

So, the risk really boils down to what's inside the fund:

•    Stock ETFs/Mutual Funds: Generally carry more risk than bond funds, but have the potential for higher returns.
•    Bond ETFs/Mutual Funds: Typically considered less risky than stock funds, but may offer lower returns.
•    Target Date Funds (ETFs or Mutual Funds): Aim for a specific retirement date and become more conservative over time, offering a balance of risk and return.

The takeaway? Don't get hung up on whether it's an ETF or a mutual fund. Focus on the investment objective of the fund and how it aligns with your risk tolerance and financial goals.

Do ETFs Pay Dividends?

ETFs typically don't distribute dividends directly. Instead, the profits from the underlying investments (the stocks or bonds the ETF holds) get reinvested back into the ETF itself. This approach helps the overall value of the ETF shares to grow over time.

Conclusion

In conclusion, both ETFs and mutual funds offer diversification and a variety of investment options. ETFs provide flexibility with real-time trading, while mutual funds benefit from expert management. Consider your investment goals, risk tolerance, and desired liquidity when choosing between the two. The underlying assets, not the structure (ETF or mutual fund), determine the true risk profile. Focus on how the fund aligns with your financial needs to make informed investment decisions.

FAQs

Here are some of the commonly asked questions about ETFs and mutual funds:

For novice investors, what's advisable: ETFs or mutual funds?

The choice hinges on your financial objectives and comfort with market dynamics. Mutual funds are often recommended for beginners due to their professional management. They offer a more guided approach to investing, which can be reassuring for those new to the financial markets and unsure about navigating the difference between ETF and mutual funds.
 

Is including ETFs and mutual funds in my investment portfolio beneficial?

Diversifying your investment in both ETFs and mutual funds into your portfolio can be a wise decision. This approach allows you to leverage the difference between ETF and mutual funds, balancing flexibility and professional management.
 

Regarding long-term investment, which is more suitable: ETFs or mutual funds? 

For long-term goals, mutual funds can be more suitable, especially for those seeking potentially higher returns through active management. The expertise of fund managers in navigating market dynamics plays a crucial role, often favouring mutual funds for long-term growth.