ETFs vs. Mutual Funds: How they differ and what to consider when investing

While ETFs are categorised under the broad bucket of mutual funds, there are some key differences between ETFs and other types of mutual funds. ETFs, unlike regular mutual funds, are traded on the stock exchange, resulting in several differences with regard to portfolio and investment management.

This article will help you understand the nuances of these two funds, the differences between the two, and factors to consider when investing in them.

• Table of Contents

1. What are mutual funds?
2. What are exchange-traded funds?
3. Types of mutual funds
4. Types of ETFs
5. ETFs and mutual funds: Differences and similarities
6. ETF or mutual fund? Which is right for you?
7. Considerations for investors: Choosing between ETFs and mutual funds
8. Key considerations

What Are Mutual Funds?

Mutual funds are an investment vehicle where money from multiple investors with shared goals and risk tolerances are pooled together. A skilled fund manager oversees this collective pool and strategically allocates the money across a diverse range of securities and assets.

The fund manager's expertise and market insights play a major role in guiding these investments to create optimal return potential for investors.

Mutual funds are managed by asset management companies.

While some mutual funds passively track a market index, replicating its portfolio, the majority are actively managed. This means that the fund manager plays a significant role in designing and managing the portfolio based on the scheme category, investment goals and regulatory guidelines. Through extensive research and analysis, the fund manager decides which securities to invest in.

This makes actively managed mutual funds typically more expensive than passively managed mutual funds and ETFs.

Mutual funds invest in the financial market but are not traded on the stock exchange. The purchase and sale of mutual fund units is executed based on the net asset value (NAV) of the fund, which is determined at the end of the trading day based on the closing prices of the underlying securities, along with other factors.

What are exchange-traded funds?

Similar to mutual funds, Exchange-Traded Funds (ETFs) aggregate money from investors and put it in a basket of securities. However, the operational mechanics of ETFs are different.

A defining characteristic of ETFs is their index-tracking nature. ETFs mirror the performance of a specific index, such as the Nifty 50 or the S&P BSE Sensex, subject to tracking error. This means the ETF's portfolio composition mirrors the constituents of the underlying index.

Thus, they are passively managed, aiming to replicate the potential returns and price movements of the benchmark index, subject to a tracking error, which is the difference between the benchmark index and the ETF’s returns. This passive management approach translates to lower operating expenses compared to actively managed mutual funds.

One of the most compelling features of ETFs is their real-time tradability. Similar to individual stocks, ETFs can be bought and sold throughout the trading day, offering investors the flexibility to potentially capitalise on market fluctuations and brief inefficiencies.

Types of mutual funds

Mutual funds can be categorised based on several parameters, including portfolio composition, oganisation structure (open-ended, close-ended and interval), management style (active vs passive), among others:

Here are the main mutual fund categories based on portfolio composition:

1. Equity funds:

• Primarily invest in stocks
• Aim for long-term capital appreciation potential
• Can be categorized by market capitalisation (large-cap, mid-cap, small-cap), investment style (growth, value etc) or investment universe (sectoral/thematic), among others.

2. Debt funds:

• Invest in fixed-income securities like government bonds and corporate bonds
• Offer potential for regular income and relative stability of capital
• Can be less volatile than equity funds

3. Hybrid funds:

• Invest in a mix of stocks and bonds
• Seek to offer a balance between risk and return
• Risk level depends upon the equity-debt ratio of the portfolio. Some funds are equity-oriented, others are debt-oriented and some may be evenly balanced between the two.

Types of ETFs

Here are the some of the types of ETFs:

Equity ETFs:

• Invest primarily in stocks
• Offer exposure to specific market capitalisations, sectors, regions etc.

Bond ETFs:

• Invest in fixed-income securities like government and corporate bonds
• Provide income and potential capital appreciation

Sector ETFs:

• Focus on specific sectors of the economy (e.g., technology, healthcare)
• Allow investors to target high-potential industries

Commodity ETFs:

• Invest in commodities like gold, oil, or agricultural products
• Provide exposure to commodity price fluctuations

International ETFs:

• Invest in stocks or bonds of companies outside the investor's home country
• Offer diversification and exposure to global markets

ETFs and mutual funds: Differences and similarities

Exchange-Traded Funds (ETFs) and mutual funds share the fundamental concept of pooling investor funds and creating a portfolio but differ in their trading mechanisms and cost structures. Here’s a comparative analysis of ETFs vs mutual funds.

1. Trading and Liquidity ETFs offer real-time trading flexibility on stock exchanges, making them highly liquid. While an NAV is calculated for ETFs, they can be bought and sold throughout the trading day based on current market prices. Thus, ETFs also have an iNAV, or indicative NAV, which is frequently updated throughout the day. Mutual funds are valued at the end of the day at the NAV, which may be higher or lower than the intra-day prices.

2.Cost structure: ETFs boast lower expense ratios due to their passive management style. Actively managed mutual funds incur higher fees for research, analysis, and management.

ETFs	Mutual Funds
Traded on stock exchanges like stocks; high liquidity.	Bought or sold at the end of the day at NAV price.
Lower expense ratios due to passive management.	Higher expense ratios due for actively managed funds due to fund manager’s role and additional fees.
Passively managed; mirrors a specific index; lower risk and higher transparency.	Most mutual funds are actively managed; meaning fund managers make the investment decisions.
More targeted investments mirroring a specific index.	Wider diversification options and exposure to various asset classes.

3. Investment Approach ETFs mirror a specific index, offering transparency and lower risk. Actively managed mutual funds involve decision-making by fund managers, potentially leading to higher returns but also increased risk.

4. Investing Process You need a DEMAT account to invest in an ETF. Mutual funds, meanwhile, can be purchased through a mutual fund house, distributor or aggregator.

Despite their distinct operational differences, ETFs and Mutual Funds share the core principle of providing investors with professionally managed, diversified investment opportunities:

1. Diversified Structure: Both ETFs and Mutual Funds offer investors a way to access a diversified portfolio of assets, effectively spreading risk across multiple holdings.

2. Professional Management: Whether it's the passive tracking of an index by ETFs or the active decision-making of Mutual Fund managers, both vehicles benefit from the expertise of financial professionals.

3. Variety: The vast array of available ETFs and Mutual Funds caters to a wide spectrum of investor preferences.

ETF or mutual fund? Which is suitable for you?

Whether to choose an ETF or a mutual fund depends on your investment goals and risk tolerance. ETFs, which trade like stocks, offer greater flexibility and lower fees, making them suitable for investors looking for trading opportunities. They also mirror an index, so they offer a passive approach to investing.

Mutual funds, on the other hand, may be actively or passively managed. They do not trade on the stock exchange and are priced at the end of the business day based on the closing value of the securities in the portfolio. Active mutual funds are suitable for investors who prefer professional management and potential outperformance of the market in the long term. Passive mutual funds may be suitable for individuals who seek market-linked return potential but do not need the trading opportunities offered by ETFs.

The ultimate choice depends on your individual financial needs and preferred investment approach.

Considerations for investors: choosing between eTFs and mutual funds

Both ETFs and mutual funds offer unique advantages. ETFs may appeal to investors seeking low-cost, passive exposure to specific market segments with intra-day liquidity. Mutual funds may be more suitable to those who value active management and seek the potential to outperform the benchmark index over long term.

The choice of your investment will depend on your financial goals, risk tolerance, investment horizon and desired liquidity.

ETFs: Flexibility and Trading

ETFs offer investors flexibility and real-time trading opportunities. If you value the freedom to buy and sell throughout the trading day, to potentially capitalise on market movements as they occur, ETFs might be appealing. Additionally, ETFs tend to have lower expense ratios due to their passive management style, making them cost-effective for long-term investors.

Mutual Funds: Professional Expertise and Active Management

Mutual funds, especially actively managed options, appeal to investors who prefer to entrust their investments to professional fund managers. These investment experts leverage their market insights and expertise to make buy and sell decisions.

Key Considerations: Risk Tolerance and Investment Style

Before making your decision, consider the following aspects:

• Risk Tolerance: Actively managed mutual funds may entail higher risk in the quest to generate alpha (outperform the benchmark index). ETFs, with their passive approach, may be more suitable for those who want their investments to be in line with broader market movements.
• Investment Style: If prefer real-time trading opportunities, you may find an ETF to be more suitable.

FAQs

Is it better to invest in ETF or mutual fund?

There's no one-size-fits-all answer. The avenue that is suitable for you depends on your preferences and financial goals. ETFs offer advantages like lower costs and real-time trading, making them suitable for cost-conscious investors and those who prefer more control over their investments.

Mutual funds, on the other hand, may appeal to those who value active management and seek potential outperformance of the benchmark over long term through the expertise of fund managers. Consider your risk tolerance, investment horizon, and preferred level of involvement before making a decision.

Do ETFs grow faster than mutual funds?

Whether ETFs or mutual funds grow faster depends on various factors, including the underlying assets, market conditions, and the specific fund's strategy. ETFs that track broad market indices can potentially perform in line with the market, while actively managed mutual funds aim to outperform the market but may also carry slightly higher risk.

What is the difference between mutual

Both mutual funds and ETFs have a net asset value (NAV), which represents the per-share value of the fund's holdings. However, the key difference lies in how they are determined and traded:

Mutual fund NAV: Calculated at the end of each trading day based on the closing market prices of the fund's holdings, minus any liabilities. Investors buy or sell mutual fund units at this NAV.
ETF NAV: While ETFs also have a NAV calculated similarly, their prices fluctuate throughout the trading day based on supply and demand on the stock exchange. Thus, ETFs also have an indicative NAV or iNAV. Investors buy or sell ETF units at the prevailing market price, which may be slightly higher or lower than the day-end NAV.

What are the disadvantages of ETF?

ETFs may involve costs like brokerage fees, high bid-ask spreads, and tracking errors.

Why choose an ETF over mutual fund?

Investors may find ETFs appealing due to their intraday trading, lower costs and transparency. Other advantages are diversification and exposure to specific sectors or asset classes that may not be covered by existing mutual funds.

Do ETFs grow faster than mutual funds?

No, the growth potential of both is entirely dependent on market conditions, investment strategies, and fund performance. Moreover, ETFs and passive mutual funds seek to match the performance of their benchmark index (subject to tracking error), whereas active mutual funds seek to outperform their benchmark in the long term.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.