Are ETFs Better Than Traditional Mutual Funds? Let’s Find Out….
August 12, 2023 Mutual Fund
When beginning to develop an investing portfolio, investors can quickly and easily become overwhelmed by waves of options like Mutual Funds, Index Funds, and ETFs. Investors looking to invest their money are likely to recommend several investment options, including Exchange Traded Funds (ETFs) and Mutual Funds.
Both ETFs and Mutual Funds have certain key characteristics that make them excellent choices for individuals who are just beginning their financial journey. Since they provide a wide range of options, Mutual Funds and Exchange Traded Funds (ETFs) are popular among investors and are regarded as beginner-friendly investments. Additionally, they provide a way for investors to diversify their holdings.
However, they differ significantly, which is important to recognise if you want to choose the best course of action for your portfolio. You see, understanding the differences between mutual funds and Exchange Traded Funds (ETFs) may help investors make the most of their investment portfolio and achieve their financial goals.
[Read: Planning to Invest in the Best Mutual Funds for the Long Term? Read This…]
Often investors question if ETFs are better than Mutual Funds. – Here, in this article, we will explain ETFs vs Mutual Funds in detail.
Mutual Funds
Mutual Funds are an older way of allowing a group of investors to hold a share in a larger portfolio. It is a professionally managed financial instrument that pools money from different investors. Mutual Funds are broadly classified as equity funds, debt funds (Fixed Income Funds) and hybrid funds. There are mainly two types of investment strategies – Actively Managed and Passively Managed.
Mutual Funds are generally bought directly from investment companies or AMCs instead from other investors on an exchange. Mutual Funds typically have minimum initial purchase requirements, and they can be purchased when the market is closed and when their Net Asset Value (NAV) is calculated and set.
Historically, Mutual Funds have been majorly actively managed, which meant that the fund paid the management team to choose stocks for the fund based on a predetermined investment strategy. However, during the past several years, the market for passive mutual funds has seen tremendous growth. The fall in the performance of actively managed schemes, relatively low risk, diversification, low cost, absence of stock selection bias, and returns parallel to the benchmark index are only a few reasons for this shift in investor sentiment from active to passive.
Exchange Traded Funds (ETFs)
While mutual funds have been around since the 1920s, ETFs are the newer kid on the investing block. In other words, an ETF does not try to outperform the relevant index; rather, its portfolio closely resembles the composition of an index in the same portion. Exchange Traded Funds can be either actively or passively managed. However, the majority are passive investments that track a major index instead of trying to beat the market.
ETFs trade like stocks and are bought and sold on a stock exchange, experiencing price changes throughout the trading day. As a result, there’s a good chance that the price at which you purchase an ETF will be different from that of other investors. Since the market continuously prices ETFs, there is always a chance for trading to take place at a higher price than the actual NAV.
Given that, the nature of both ETFs and Mutual Funds is very similar. However, they differ in their functionality and associated risks. Know these differences to make a well-informed decision.
Here’s a Quick Comparison: Mutual Funds vs ETFs
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| Investment style | It may follow active or passive management, but primarily active | It may follow active or passive management, but primarily passive |
| Risk Profile | Carry high risk, and it may vary depending on the category of mutual fund | Low risk as compared to mutual funds. It mainly replicates the underlying index performance |
| NAV (Net Asset Value) | Traded at the closing NAV | Traded anytime during the trading day, and their prices keep changing |
| Types | Equity funds, debt funds, hybrid funds, Contra funds, value funds, Index funds and ELSS etc., | Equity-oriented ETFs, Debt-oriented ETFs, Commodity ETFs (Gold and Silver), Sector ETFs, etc., |
| Expense Ratio | Mutual Funds have a slightly higher Expense Ratio | ETFs come with lower expenses |
| Buy/Sell | Mutual Funds can be only purchased directly from the funds at their Net Asset Value, which is fixed throughout the trading day | ETFs can be purchased and sold anytime at their market price |
| Liquidity | Lower liquidity as compared to ETFs | Higher liquidity as compared to mutual funds. |
| Tax Implications | Mutual Funds come with tax liabilities – Long Term Capital Gains or Short term capital gains | ETFs have fewer 'taxable events' than mutual funds-which can make them more tax efficient |
| Suitability | For investors with a long-term approach, especially if investing in equity-oriented schemes | ETFs can be a good choice for novice investors, who can rely on the scheme to generate benchmark returns |
Are ETFs Safer Than Mutual Funds?
It’s impossible to say whether Mutual Funds, by and large, are better or safer than ETFs simply because there are various factors suitable for different investors, and both ETFs and Mutual Funds involve a certain level of risk for investors. There is no ETF or Mutual Fund that is completely risk-free.
While the structure of ETFs and Mutual Funds provides some risk advantages as they are diversified. But the underlying assets that make up each fund also have their own risks. For instance, concentrated funds, like an ETF highly invested in the energy industry, may carry additional risks.
How to Choose between ETFs And Mutual Funds?
Now, which investment to choose essentially depends on your financial needs, investment goals, tolerance for risk, and investment style. To decide if an ETF or a Mutual Fund is the appropriate choice for you, carefully consider these aspects in addition to the ones mentioned above.
Both investment options we have discussed above allow you to build an excellent investment portfolio and generate significant returns. However, both have their own perks and drawbacks, which should be kept in mind while selecting. The investor’s requirements determine the best choice. Asking yourself the following questions can help you choose the best investment option:
- What are your financial goals?
- What is your risk appetite?
- What is your investment horizon?
- What are your liquidity concerns?
- What are your taxation concerns? etc.,
[Read: How to Choose Mutual Funds For Your Investment Portfolio]
As mentioned earlier, there are a lot of elements to look at and weigh when deciding whether Mutual Funds or ETFs are a better choice for your portfolio. It’s crucial to bear in mind that you are not necessarily relegated to choosing one or the other – you can invest in both!
Owning both ETFs and Mutual Funds could be a prudent strategy as they each provide opportunity and stability. For instance, an actively managed mutual fund can provide you with additional upside potential than the index it is tracking. However, adding a Passively Managed ETF to your portfolio could provide stability from downside risk and volatility linked to Actively Managed Mutual Funds. However, as both Mutual Funds and ETFs are diverse investment vehicles, they could be the best choice for either an experienced or a novice investor’s portfolio.
Therefore, just remember before investing, do your homework, consider the risks, and speak with a SEBI-registered investment advisor for further guidance if needed. So, considering the prevailing market conditions decide your investment strategy carefully. And choose the best suitable investment option by comparing the differences between ETFs and mutual funds.
This article first appeared on PersonalFN here
