Investing in financial markets is not an easy task. There are many ups and downs in the financial market of investment. . An investor should know the importance of diversifying the portfolio. There is a famous saying in the financial market industry, that is, “Do not keep all your eggs in one basket.” It simply means, ‘do not invest all your capital into one one asset class, or one stock, diversify into other asset classes, like gold, cryptocurrencies, and many more. know more about ETF vs mutual funds below.
As we all know, the equity market is the most volatile market out of all. Therefore, investing the entire capital in the equity markets will expose the capital to much higher risk as compared to other asset classes.
To diversify the portfolio with less direct equity exposure, one can look at either an Exchange Traded Fund (ETF) or Mutual Fund. Both of these options are the best portfolio diversification option for the investor. Those investors, who do not have time and knowledge to analyze stocks and their respective industries, can go for ETF or Mutual Fund investments.
While both might sound similar, they serve different purposes. Both ETF vs mutual funds include stocks and bonds in their portfolio, thus, generating good returns. Now, let us see what factors affect an investor’s decision. However, understanding the basic differences between ETF and Mutual Funds is essential before you choose any.
Exchange-Traded Fund (ETF)
An ETF is a fund created by pooling money from investors. The pooled money is then invested into specific financial instruments such as an index.
In an ETF, investors are allowed to buy and sell individual indices. You can invest into the proportion of an index in an exchange-traded fund, similar to the proportion available on Nasdaq or the New York Stock Exchange (NYSE). It is a form of passive investing.
The trend in actively managed ETFs has been rising in the past couple of years. There are quite a few fund managers who beat indexes every year, by selecting quality companies of the sectors that have the potential to outperform in the future. Also, ETFs are comparatively new, as compared to
So for all the research and other services provided by an ETF, the investor has to pay a certain fee. The fee is collected by fund houses which are decided upon the expense ratio or a certain percentage of the Asset Under Management (AUM).
The working of a Mutual Fund is similar to that of an ETF. A mutual fund is a fund created by asset managers and funded by investors. The funds are collected via New Fund Offerings. New Fund Offerings is a period given to retail investors, in which investors can buy the funds at a cheaper rate.
The purchase and sell price of a Mutual Fund is called Net Asset Value. Net asset value is decided as per the closing price of all the assets that are clubbed in the fund.
Mutual funds are managed actively by the fund managers in terms of buying and selling the stocks in the portfolio. Therefore, mutual funds are expensive to run and own. Also, the mutual fund managers have to maintain cash reserves to fund outflows from the fund at the end of the day.
If the manager does not have sufficient reserves, then the fund has to sell some of its shares in the market, to meet the investor’s exit criteria. If the net inflow at the end of the day is higher, then the fund has to buy some shares from the market.
Difference Between Mutual Funds And ETFs
Purchase Price Determination
The price of an ETF fluctuates throughout the day, as they are traded in the secondary market. Also, the price depends upon the demand and supply of the underlying asset.
Whereas, the Net Asset Value of mutual funds is always updated after the trading session has ended, after receiving all the orders.
ETFs are noticeably more tax efficient, as they are traded on a stock exchange and can be redeemed anytime. On the other hand, the mutual fund is redeemed at the mutual fund house.
Therefore, if a lot of people sell off mutual fund units, then the fund will have to liquidate the holding in huge sums and might have to pay capital gain tax on the sum. Thus, mutual funds are less tax efficient.
Since Exchange Traded Fund is traded on the exchanges, they are not actively managed by the manager. Therefore, the charges are less on the ETF as compared to the mutual fund. Also, not every mutual fund investment is expensive, some mutual funds offer free off-loading of securities.
Commission And Other Charges
An investor requires a brokerage account to invest in an ETF. Therefore, a commission to the broker has to be paid in case of an ETF. However, recently, the majority of brokerage houses charge zero percent commission on an ETF investment.
A Demat/brokerage account is not required for investment in Mutual Funds. However, the charges and commission for investing in mutual funds depend upon the fund and broker you choose.
Which Is The Right Investment For You? And Why?
To minimize the risk exposure of the portfolio, you should diversify your investments. ETFs and Mutual Funds are considered as one of the best diversification asset classes. These points will make you help you in deciding the best investment class for you:
Invest in ETF when
You Trade Passively:
If you are planning to start your trading career, or want to follow a broad-based index to trade in the stock market. ETF is the right option. Because in an ETF you cannot use any trading techniques. The overall market gain or loss is what you will earn. In mutual funds, you can sell a fund portfolio and be an active seller of a fund.
You Want Tax Efficiency
You can invest in an ETF if you need tax efficiency and if it is important. ETFs are traded in the secondary market, just like stocks. Therefore, the redemption mechanism is easier as compared to mutual funds.
Reducing Time Spent On Research
ETF investment is best if you do not want to spend time on research and want your portfolio to have a niche exposure. Because, the majority of ETFs are copy-paste indexes, therefore, they are not actively managed.
Also read: Bullish vs. Bearish Market – Explained
Invest in Mutual Funds When
You Are A Passive Trader
Not everyone is familiar with trading techniques and setting targets therefore, for such investors, the best option is to invest in mutual funds.
Your ETF Is Thinly Traded
Some ETFs trade on very low volumes, therefore sometimes, the spread becomes wide and traders incur losses. Therefore, if your chosen ETF is thinly traded, then rather, go for mutual fund investment.
You Find Low-Cost Fund Or Actively Managed Fund
Some of the mutual funds have low annual charges which will help you in saving up a lot of money, in short, increasing your earnings.
Also, actively managed funds have the potential to beat index earnings, therefore, it is better to invest in an actively traded fund.
- Some of the ETFs have low trade volumes, therefore, sometimes the purchasing price of the underlying asset might be higher. This difference between the bid and ask price is called the spread.
- Sometimes the cost of investing is higher if the cost is compared with equity share investing. The broker might charge the same fee/commission, however, there is no management fee charged for trading equity shares.
- The yields provided by dividend-paying exchange-traded funds are lesser as compared to owning individual high-yield providing stocks.
- It is difficult for a non-actively managed fund to beat the index’s returns. However, in the long run, mutual funds might prove to be a good wealth builder.
- You can not decide the holdings of a fund. Therefore, there would be some stocks, that would be included in the fund, that you might not prefer having in your portfolio.
- The cost of managing a mutual fund is usually higher as compared to any other fund. The fee for an actively managed fund is the most compared to other mutual funds.
- When compared to ETFs, mutual funds are less tax efficient. Because investors have to redeem the units from a fund house and not the stock exchange.
Bottom Line – Which Investment Product Is Safer?
To be honest, neither an ETF is safe nor a Mutual Fund is 100% safe like a fixed income product. The safety of each type depends upon the type of ETF or Mutual Fund you choose. We know that equity markets are riskier than bond markets because of the high volatility. Similarly, a bond fund would be a safer investment than an equity mutual fund. But the long-term income generated from the stock markets can more than cover the risks with the right choice.