ETF versus Mutual Funds – What is the Difference?
Every individual has certain goals in life, be it accessing good education, finding a suitable career or purchasing a house and building a family. And each of these goals require a good amount of money. 27-year-old Ajinkya managed to get a good start after he completed his engineering degree and he has been associated with a large MNC for the last three years. He has saved up some money and is keen on purchasing a new house in Pune over the next five years. While he will opt for the EMI route to secure the house, he has to accumulate enough corpus for a down payment. With the level of inflation currently, there is little chance of accumulating the corpus by merely saving his money or choosing an FD. So what other options can he pursue?
Just like everybody else, Ajinkya has also heard of mutual funds. He has seen various advertisements espousing the benefits of mutual fund investments and is keen on trying the investment route to bolster his savings.
Types of mutual funds
Mutual funds are professionally managed investment vehicles funded by a wide range of unit-holders. Mutual funds offer investors returns in line with the quantum of units they hold, and these returns are garnered through trades in diversified holdings. Based on their holdings, mutual funds can be categorised as debt funds, equity funds or hybrid funds and you can choose the best scheme for your financial goals by understanding the different schemes and the underlying risk-return equation.
Historically, equity funds, which invest their corpus in equity instruments such as company shares, have offered investors the highest returns, as compensation for undertaking comparatively higher risks. Alternatively, debt funds are considered a safer option as they invest in money market instruments and, in line with the risk-return ratio, they offer lower returns than equity funds. Hybrid funds combine the two asset categories, and offer investors potentially higher returns than debt funds, at risks lower than pure equity schemes.
Mutual funds are also distinguished on the basis of their management. For instance, active mutual funds are proactively managed by professional fund managers who strive to achieve market-beating returns based on their knowledge and expertise. Such funds charge a higher commission as compared to passive mutual funds because the latter does not involve active fund management. Passive mutual funds are also termed as index funds, because they benchmark themselves against a chosen index and track the composition and returns offered by the underlying index. Therefore, passive mutual funds offer returns which are in line with the market and they act as a good option for novice investors like Ajinkya.
Given his risk profile and financial goals, Ajinkya chose to move forward with an exchange traded fund or ETF, a popular sub-category under passive funds.
ETF versus mutual funds
ETFs are fund schemes which trade on exchanges in a manner similar to stocks. Since they trade continuously, they are more liquid than other fund schemes. ETFs can track all types of indices, be it stocks, commodities or debt and, given their passive nature, they charge lower fees than other schemes. A popular example of an ETF is the Nifty50 ETF and many fund houses offer passive schemes which track the Nifty50 index, helping investors participate in the growth of major companies.
Considering the ETF versus mutual funds aspect, one of the biggest benefits of ETFs is that it charges a lower commission, meaning that almost all of your money is being invested in units. This ensures that you have a larger share-holding in the scheme, at the end of your tenure. Another thing to consider, when looking at ETF versus mutual funds, is the fact that ETFs are much more transparent in their holdings. You can track your investment holdings by simply tracking the underlying fund. Thirdly, in ETF versus mutual funds, you receive greater diversification through ETFs as your corpus is allocated to all the assets making up the underlying index. So, if you invest in a sectoral equity fund, you only gain exposure to the companies in that sector but, with ETFs, your money is invested in profitable companies across sectors, offering you a better prospect in terms of returns.
If you take into account ETF versus mutual fund taxes, there are two major advantages in picking ETFs. Structural differences between the two lead to lower capital gains tax on ETFs. Further, ETFs attract capital gains tax only at the time of sale, while other mutual fund schemes pass the capital gains taxes on to investors throughout the lifecycle of the investment, making ETFs a cheaper proposition.
As such, there is a simple answer to the ETF versus mutual funds question – while mutual fund is an investment vehicle, ETFs are a subcategory or an option available under the mutual fund investment route. Now that you are clear on the ETF versus mutual fund query, it is time to pick your scheme and start investing!
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