Mutual Fund vs. ETF: An Overview
Two much-talked about investment packages that people are increasingly opting for these days are Mutual Funds (MFs) and exchange-traded funds (ETFs).
ETFs vs Mutual Funds
Simply put, a Mutual Fund involves a pool of money from a group of investors with similar objectives and risk appetites being invested across a range of securities and assets. The investment pool is managed by a fund manager, who makes an assessment of the type of securities to put the money into. The investors can purchase the MF units, which generate returns in line with the performance of the underlying assets. Being professionals with in-depth knowledge of markets and different types of securities, fund houses and managers build a diversified portfolio with the aim of generating maximum returns for investors.
Broadly, MFs can be categorized into three types depending on the type of asset allocation: equity funds, debt funds and hybrid funds. As the name suggests, equity funds are those where a major portion of investment is into shares of various companies. Similarly, debt funds involve money put into a host of debt instruments like government bonds and securities, among others. And then there are hybrid funds, where investments are made across both debt and equity options.
Then there are exchange-traded funds that are similar to MFs in that both of these are investment options where money pooled in from investors is put into a basket of securities. An ETF basically copies an index, which means that it usually consists of stocks of different companies as present in the particular index. It tracks the performance of a particular index and can be traded on the stock exchanges.
Difference between ETF and Mutual Fund
The main difference between ETF and Mutual Fund is that while ETFs can be actively bought and sold on the exchanges, just like any other shares, one can only purchase a unit of a Mutual Fund from a fund house even though these can be listed on the exchanges. In the same way, ETFs generally do not have any minimum lock-in period and can be bought and sold by an investor at their convenience. However, a Mutual Fund unit usually involves some minimum lock-in, and selling the units before this period can also attract a penalty. Also, MFs are actively managed by fund manager or professionals, while ETFs are passive investment options that track the performance of an index.
By The Numbers
The United States is the world's largest market for mutual funds and ETFs, accounting for 46.4% of total worldwide assets of $63.1 trillion1 in regulated open-end funds as of December 2020. According to the Investment Company Institute, as of December 2020, U.S.-registered mutual funds had $23.9 trillion1 in assets, compared with $5.4 trillion in assets for U.S. ETFs. At year-end 2020, there were 9,027 mutual funds2 and 2,296 ETFs in the U.S.
Mutual Funds
Mutual funds typically come with a higher minimum investment requirement than ETFs. Those minimums can vary depending on the type of fund and company. For example, the Vanguard 500 Index Investor Fund requires a $3,000 minimum investment, while The Growth Fund of America offered by American Funds requires a $250 initial deposit.
Many mutual funds are actively managed by a fund manager or team making decisions to buy and sell stocks or other securities within that fund in order to beat the market and help their investors profit. These funds usually come at a higher cost since they require substantially more time, effort, and manpower for research and analysis of securities.
Purchases and sales of mutual funds take place directly between investors and the fund. The price of the fund is not determined until the end of the business day when net asset value (NAV) is determined.
Two Kinds of Mutual Funds
There are two legal classifications for mutual funds:
Open-Ended Funds. These funds dominate the mutual fund marketplace in volume and assets under management. With open-ended funds, the purchase and sale of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue. So, as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of an individual's shares is not affected by the number of shares outstanding.
Closed-End Funds. These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.
Exchange-Traded Funds (ETFs)
ETFs can cost far less for an entry position: as little as the cost of one share, plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
ETF Benefits
The unique ETF creation/redemption process results in ETF prices tracking their net asset value closely, since the APs monitor demand for an ETF closely and act promptly to reduce significant premiums or discounts to the ETF's NAV.
The creation/redemption process also means that the ETF's fund manager does not need to buy or sell the ETF's underlying securities except when the ETF portfolio has to be rebalanced. Since an ETF redemption is an "in kind" transaction as it involves ETF shares being exchanged for the underlying securities, it is typically tax exempt and makes ETFs more tax efficient.
Thus, while the process of creating and redeeming shares of a mutual fund can trigger capital gains tax liabilities for all shareholders of the mutual fund, this is less likely to occur for ETF shareholders who are not trading shares. Note that the ETF shareholder is still on the hook for capital gains tax when the ETF shares are sold; however, the investor can choose the timing of such a sale.
Mutual Fund vs. ETF Redemption Example
For example, suppose an investor redeems $50,000 from a traditional Standard & Poor's 500 Index (S&P 500) fund. To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn't sell any stock in the portfolio. Instead, it offers shareholders "in-kind redemptions," which limit the possibility of paying capital gains.
Which one to Choose between ETFs and Mutual Funds?
Both the investment options, i.e. ETF and Mutual Fund, help investors build a diversified investment portfolio. However, there are many factors that one must consider before choosing a fund. The factors such as,
Investor’s risk tolerance level
Investors time horizon
Investor’s Financial goals
The tax savings strategy
Liquidity of investment
Once the investor has narrowed down the above, they can choose to invest in ETFs vs mutual funds based on their requirements. For some investors, liquid investments take precedence over long term investments. Exchange Traded Fund (ETFs) offer more flexibility and better returns in the short term. At the same time, investors who invest in mutual funds must stay invested for a more extended period which helps them create a corpus for the future. The decision depends on the investor as one must consider all the factors before choosing to invest in an ETF vs Mutual Fund.
Additionally, there is another practical point to note before choosing to invest in an ETF. An investor must have a demat account or a trading account to invest in an Exchange Traded Fund in India. If an investor is not comfortable opening a demat account or a trading account, ETFs are not appropriate for them. However, investors can choose to invest in passively managed indices through index funds. Index funds are a type of mutual fund scheme that mimics the portfolio composition of a market index. For instance, an investor can choose to invest in an ABC ETF Nifty 50 index fund of a fund house.