Difference Between ETF and Mutual Fund

Exchange Traded Funds vs. Mutual Funds - What is the Difference?

In the world of investing, Exchange-Traded Funds (ETFs) and mutual funds stand out as two popular options for building diversified portfolios. Both are designed to include a mix of assets, making them a convenient way for investors to spread risk. However, despite their similarities, these funds have key differences that can influence your investment strategy.

Understanding these distinctions is crucial to selecting the option that best aligns with your financial goals. In this article, we’ll explore what exchange traded funds (ETFs) and mutual funds are, highlight their main differences, and delve into what each offers to investors.

Understanding Exchange Traded Funds vs. Mutual Funds

Before we dive into the difference between ETFs and Mutual Funds, let’s quickly understand what these two investment options are.

ETFs  are collections of assets like stocks or commodities that trade on stock exchanges throughout the day, much like regular stocks. ETFs are passively managed and typically track a benchmark index.

Mutual funds combine money from multiple investors to invest in stocks, bonds, or other assets, managed by a professional fund manager who aims to generate higher returns. These funds are purchased directly from Asset Management Companies (AMCs) or fund houses and traded only at the end of the day based on the Net Asset Value (NAV).

Exchange Traded Funds (ETFs) vs. Mutual Funds: Key Differences

Investors today are increasingly exploring options to grow their wealth efficiently. Among the most debated choices are exchange traded funds vs mutual funds (ETF vs MF). Both options pool money from investors to purchase a diversified mix of assets like stocks, bonds, or other securities, but they operate differently. Here's a closer look at the difference between ETFs and Mutual Funds explained elaborately to simplify your decision-making:

Trading Flexibility

The primary difference between ETFs and mutual funds lies in how they are traded. ETFs, or Exchange-Traded Funds, function like stocks and are bought and sold on stock exchanges throughout the trading day, allowing investors to track real-time prices and trade whenever they choose. 

In contrast, mutual funds are only traded once daily after the market closes, with prices calculated based on the fund’s Net Asset Value (NAV) and transactions processed through fund houses. 

To simplify, ETFs are like an online shopping platform where prices fluctuate and purchases can be made anytime during the day, while mutual funds resemble a traditional store that operates after 5 PM and offers a fixed price for all transactions.

Expense Ratios and Fees

Generally, ETFs have lower expense ratios compared to mutual funds because most ETFs passively track an index (e.g., Nifty 50). However, ETFs may involve brokerage fees for each transaction.

Mutual funds often have higher expense ratios due to active fund management. Some may also charge sales loads or redemption fees, especially if you exit within a lock-in period.

Holding Periods and Taxation

ETFs do not have lock-in periods, making them more flexible for investors who want liquidity. Taxation is straightforward; long-term capital gains (for holdings over 1 year) are taxed at 10% without indexation.

Mutual funds may impose penalties for early redemption, with holding periods ranging from 90 days to 3 years. For equity-oriented mutual funds, long-term capital gains (LTCG) are taxed at 10% beyond ₹1 lakh, and short-term capital gains (STCG) are taxed at 15% if the fund is held for over a year. Debt-oriented funds follow different rules, and this should be clarified. However, long-term equity mutual funds can offer tax benefits, as gains beyond 1 year are often tax-exempt up to a certain limit.

So, think of ETFs as your regular savings account—withdraw anytime without penalties. Mutual funds are like a fixed deposit, where early withdrawals might attract a penalty.

Management Style: Passive vs. Active

Most ETFs are passively managed, tracking an index like the BSE Sensex or Nifty 50. This approach reduces costs but limits the potential for outperforming the market.

Mutual funds are actively managed by fund managers aiming to beat the market, making them appealing for investors seeking potentially higher returns at higher costs.

Diversification

Both investment options provide diversification but in different ways. ETFs offer exposure to broad indices or sectors, making them ideal for market-wide exposure. Mutual funds include asset-class-specific options like equity, debt, or hybrid funds, offering a tailored approach to risk and return preferences.
 

ETFs vs. Mutual Funds: Comparative Table

To further clarify the distinction between ETFs and mutual funds, the table below highlights their key differences in a simplified format.

Exchange Traded Funds (ETFs) vs. Mutual Funds: What are the Similarities?

While ETFs and mutual funds have their differences, they also share several key similarities that make them popular investment options for individuals:

Diversified Structure

Investors can access a diverse array of assets, including stocks, bonds, and commodities, through mutual funds and exchange-traded funds (ETFs). This diversification provides a balanced approach to investing by lowering the risk associated with depending solely on the performance of one asset.

Professional Management

The knowledge of financial experts is advantageous to investors. While ETFs are frequently passively managed, they are nonetheless created and maintained by skilled professionals to efficiently track particular indices or asset classes, whereas fund managers actively make investment decisions in the case of mutual funds.

Variety of Choice

Investors can select ETFs and mutual funds from a wide range of options. They can choose ETFs or mutual funds that match their financial goals, risk tolerance, and investment preferences. Whether you are a conservative investor seeking low-risk options or an aggressive investor looking for high-growth potential, both ETFs and mutual funds provide ample choices to build a tailored portfolio.

Mutual Fund vs ETF- How to Choose?

Both investment options we have discussed above allow you to build an excellent investment portfolio and generate better returns. However, both have their own perks and drawbacks which should be kept in mind while picking any one. The right selection depends entirely on your financial goals, experience levels, risk appetite and a few other factors. Before selecting the right option, ask yourself the following questions:

• What is your risk appetite? 
• What are your liquidity concerns? 
• What are your financial goals? 
• What is your investment horizon?
• Do you have any tax-saving strategies?

 
After answering these questions, you will be able to decide what is the right option for you. Mutual funds may require you to stay invested for a longer period of time, but help you generate higher returns for the future. But if you need the flexibility of managing your funds and want to stay invested for a short-term, then an ETF can be a great option for you. The decision is completely yours, but you have to make it carefully for your own good. 
 

Conclusion

Both mutual funds vs ETFs deliver significant investment opportunities to young investors. That means they help in building an excellent investment portfolio by generating better results. On the other hand, both have their advantages and disadvantages which you must keep in mind while choosing the one. Whatever you select depends upon an individual investor's financial goals, acceptable costs, investing style, etc.

So, decide with due care and select the right investment option by studying the ETF and mutual fund differences. For more details and guidance, you can contact 5paisa.