In the modern investing world, there are two products that seem to take center stage in the discussions on diversification of portfolios – Mutual Funds and Exchange Traded Funds (ETFs). While both are designed to help investors grow their wealth and provide access to diversified portfolios, the structure of the system, its management and cost mechanics are all very different. Comparing Mutual Fund vs ETF is very important in realizing the nature of each as per some certain financial purposes as well as styles of investments.
Understanding the Basics What Is Mutual Funds & ETFs?
Mutual Funds – They are a type of investment fund which bring the money of a large number of investors together and hold a portfolio of securities – stocks, bonds, money market instruments – as a team. These typically are handled by professional fund managers who are actively involved with making investment decisions within a fund in order to achieve the stated objectives of the fund. Mutual funds are either purchased or sold at the close of trading day at the price of Net Asset Value (NAV).
In contrast, ETFs (Exchange Traded Funds) are also a collection of securities but they are bought and sold on the stock exchanges like stocks. Their prices change during the trading day with influence by supply and demand. Many ETFs try to follow a certain index, like the nifty 50 or s&p 500 and in order to do so, they will typically take a passive management strategy.
The Structure And The Management: Active & Passive
One of the major differences between mutual funds and ETFs is management.
Mutual funds are usually actively managed meaning a professional manager is taking buy-sell decisions based on research and strategy. The goal is to do better than some benchmark index. This active management can potentially result in higher returns and have higher fees and above average potential for underperformance.
ETFs, by contrast, are most commonly passively managed due to the fact that they attempt to track the performance of a given index. This approach keeps the cost of management to a minimum, and provides transparency as for what assets the ETF is holding investors can see precisely what it will be holding. However, passive management does not allow much scope for beating the market as ETFs are structured to follow the market and not to beat it.
Pricing and Trading Flexibility
Pricing structure is one of the most noticeable differences when comparing Mutual Fund vs ETF.
Mutual funds are priced once on daily basis after the trading hours and is based on its NAV. Investors buy units or sell unit on end of day price irrespective of the time order. This process makes them suitable for investors who are on the long term process as compared to investors who require flexibility in the intra-day trading.
ETFs on the other hand can be purchased and sold throughout the day on exchanges, on market value. This helps the investors to have some flexibility in the real-time wherein they can buy or sell the units as per their convenience or need just like stocks. ETF’s also allow for advanced trading strategies like limit orders and margin trading to be used that is not an option with mutual funds. However, considering the fact ETFs are traded like stocks, the value of ETFs in the market may fluctuate by a tiny bit from the proper NAV due to the supply demand.
Cost Comparison: Expense Ratios & Fees
When it comes to cost, however, ETFs are often a winner.
Mutual funds will typically have a higher expense ratio in order to cover the cost of active management and research as well as administrative costs of management. Along with the type of fund and investment time horizon, they may also feature entry or exit loads. These costs can eat away at overall returns; especially in the long run.
ETFs usually have cheaper expense ratios as they are passively managed. There are no sales loads or commissions on buying from the fund house but the investors have to pay brokerage fees on trading ETFs on the exchange. For cost conscious investors, ETFs can be more efficient, especially with those who do not trade very frequently.
Liquidity and Accessibility
Liquidity is another factor which has an effect on preference of investors.
Mutual funds can only provide liquidity during the end of trading day on the basis of calculated NAVs. Redemption may take one or more business days for the money to appear on the investor’s account.
ETFs, being exchange-listed provide teachers with liquidity on the spot. Investors are able to buy and sell positions at any time of the market hours. This flexibility is attractive to traders/investors that desire to be able to react quickly to market movements. However, the liquidity of ETFs is dependent on trading volume – trading volume of ETFs that trade at low volume is likely to be available for larger bid-ask spreads, which have minor affects on the returns.
Transparency & Efficiency in Taxation
ETFs are often more transparent, taking into account the obligation to report the day-to-day publicly available holding. Investors know what exactly are included as assets and what is what proportion. Mutual funds, on the whole, are comprised of a fund that does not give the information on a daily or even regular weekly basis and so they have to provide less frequent information about the portfolio structure.
When it comes to taxation, ETFs are also more tax efficient, on the whole. Because of the nature of their creation (and redemption) in-kind, ETFs rarely pay capital gains, unless the owners of the ETFs choose to sell their shares. Mutual funds, however, can incure taxable capital gains by fund managers making buys or sells of securities in the fund’s portfolio – even when their investors don’t sell off their units.
Which one should investors choose
Choosing the type of the investment – Mutual Fund vs ETF Generally the investment goals, the risk appetite, and the way of trading are determining what type of investment to choose from.
Mutual Funds may suit those investor to invest in managed funds, are comfortable with buy and hold and wish to invest their money in systematic investing plans (SIPs) They are also ideal for beginners who are seeking convenience, but not having to track the market day-in and day-out.
ETFs are better for cost-conscious investors that prefer to be the masters of their (and their money’s) destiny when it comes to trading. They are great for the investor who is looking for a cheap way to be exposed to indices or certain sectors.
Final Thoughts
Both Mutual Funds and ETF’s are important tools to help diversification and in building wealth. Mutual funds offer the simplicity of not to mention professional management, but ETFs offer transparency, cost efficiency and liquidity. The choice all comes down to the extent one wants to be involved in the investment process.
Essentially, mutual funds and ETFs are not one of the competitive weapons but a complimentary weapon. A well-balanced portfolio may include both – with mutual funds for long term and systematic growth and ETFs for tactical exposure to the portfolio with markets at any point in time. Understanding their structure, and how they differ, is the key to their alignment to individual investment strategies and financial goals.
Also Read: CFD Meaning and How It Applies to Modern Trading
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