ETFs vs. Mutual Funds: What is the Difference, and Which is Suitable For You?

Investing can be a beneficial way to potentially grow wealth for various financial goals. However, making wise investment decisions is crucial. Given the number of options available, choosing a suitable avenue to park your hard-earned money can be challenging. 

Two popular but often-confused investment avenues are mutual funds and ETF funds (exchange-traded funds). Both have their unique advantages and can be suitable for different types of investors. This article will help you understand the key differences between ETFs and mutual funds to help you make an informed decision. 

What are mutual funds?

Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional fund managers who design the portfolio based on the fund category, their investment strategy, and the scheme’s investment objectives. Mutual funds may be actively managed – where the fund manager can decide the mix of securities in the portfolio (based on certain broad regulatory guidelines). They can also be passively managed, where the portfolio is designed to replicate a broader stock market index. 

There are several mutual fund categories. Some invest in stocks, some in bonds, and some in a combination of both. 

Advantages of mutual funds

• Professional management: Most mutual funds are actively managed by experienced professionals who make investment decisions on behalf of investors.
• Diversification: By investing in a variety of assets, mutual funds spread and thereby mitigate risk.
• Convenience: Mutual funds can be suitable for individuals who do not have the time, knowledge, or inclination to manage their investments actively.
• Affordable investing via Systematic Investment Plan (SIP): Investors can opt for SIP to invest a fixed amount regularly in the scheme of their choice. This helps them invest in affordable instalments. 

What is an ETF (Exchange-Traded Fund)?

An ETF, or Exchange-Traded Fund, is a type of investment fund that is traded on stock exchanges, much like individual stocks. ETF funds are usually designed to track the performance of a specific index and offer investors a way to buy a broad basket of assets through a single investment. It also helps investors align their investment’s performance to that of the broader market, subject to tracking error (the difference between the performance of an ETF and the index that it replicates). 

ETFs may invest in stocks, bonds or commodities, depending on the nature of the index each is tracking. 

Here are some of the advantages of ETFs:

• Intra-day liquidity: Since ETFs are traded on stock exchanges, they can be bought and sold throughout the trading day at market prices.
• Lower costs: ETFs typically have lower expense ratios compared to actively managed mutual funds, making them relatively cost-effective.
• Transparency: The holdings of an ETF are disclosed daily, allowing investors to see exactly what assets they own.

Key differences between ETFs and Mutual Funds

Understanding the differences between ETFs and mutual funds can help you decide which one is better suited for your investment needs.

• Trading Flexibility:

• Mutual funds: Units can be bought or sold at the end of the trading day based on the applicable net asset value (NAV).
• ETFs: They allow for intra-day trading as they are traded on the stock exchange. So, at a given point in time, they can trade at a premium or discount to their end-of-day NAV.

• Cost:

• Mutual funds: Actively managed funds usually have higher expense ratios.
• ETFs: They typically have lower expense ratios as they are not actively managed.

• Management style:

• Mutual funds: A majority of them are actively managed, with the fund manager seeking to potentially outperform the market in long term. The fund manager designs the portfolio, selects its underlying securities and buys or sells securities based on their market performance, their forecasts, investment objective and investment strategy. 
• ETFs: They are passively managed and usually track a stock market index. The portfolio mirrors that benchmark index, comprising the same securities in the same proportion. 

• Investing requirements:

• Mutual funds: Can be bought without a demat account. 
• ETFs: Need a Demat account to invest

Which one is right for you?

Choosing between ETFs and mutual funds depends on your investment goals, risk tolerance, and preferences.

ETFs may be suitable if:

• You prefer lower costs: The expense ratio of ETFs may be lower than that of actively managed mutual funds as the former mirror a stock market index and follow a passive investing strategy. 
• You seek trading flexibility: ETFs are suitable for investors who want to trade frequently.
• You want to mitigate decision-making risk: If you want your investment to mirror the performance of the broader market and do not want a fund manager’s stock selection to influence returns, you may consider ETFs. 

Mutual funds may be suitable if:

• You seek professional management: Mutual funds are suitable for investors who want a professionally managed portfolio and an active investment strategy that seeks to outperform the market. 
• You want to invest in instalments: Mutual funds may be suitable for those who want to invest in regular instalments through SIP. ETFs do not typically offer this option. SIPs allow you to invest a fixed amount at regular intervals. You can start investing with as little as Rs 500. You can also choose the instalment frequency. Options include daily, weekly, monthly and quarterly.  

Diversification: Using both ETFs and mutual funds

For greater diversification, investors can consider using both ETFs and mutual funds in their investment strategy. By combining these two types of funds, you can enjoy the trading flexibility of ETFs with the professional management and opportunity for potential market-beating returns in the long term provided by active mutual funds. 

In summary, both ETFs and mutual funds have unique advantages and can complement each other in a well-diversified investment portfolio. By understanding their differences and aligning them with your investment goals, you can make a more informed decision that suits your financial needs.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.