ETF vs Mutual Fund is one of the top question in every investor’s mind. So, here we review the difference, performance and investment methodology of ETFs and mutual funds.
Mutual funds and ETFs are two very different investment products. But, there are some similarities between ETFs and mutual funds as well. Moreover, ETFs are grabbing attention from mutual fund investors due to their unique features. Like they can they be traded like a common stock, very low fees and other useful applications of the fund. So, we will discuss in detail about the different benefits of investing in ETF and Mutual Funds.
Exchange Traded Funds (ETFs): Meaning
ETFs are the class of exchange-traded investment product in which investors pool money in the fund from a different class of investors. The fund invests in a particular index, commodity, bonds or some other asset class in the market. Unlike a mutual fund, ETFs are traded on the terms of common stocks.
The main characteristic of ETF is that its unit is treated a unit of stock and price is determined on a real-time basis. It tracks a particular index of its asset class.
Mutual Funds: Meaning
Mutual funds are the professionally managed fund which pool money from numerous small investors. The fund invests in stocks, bonds of publicly traded companies and government securities based on the objectives of the fund. There are various categories and types of mutual funds like equity fund, debt fund, balanced funds etc.
ETF vs Mutual Fund: Comparison
1. How does ETFs and Mutual funds work?
The creation of ETF units is more complex than creation of new mutual funds units. The process begins with the creation of ETF units. ETF shares are not directly sold to the public for cash. The sponsor of the Fund (Asset management company) takes shares of the companies comprising the index from different categories of investors like authorized participants, Large Institutional Investors.
In return, it issues them a large block of ETF units called “creation units“. The dividend (cash component) which are given on the stocks is also taken from such investors in exchange of ETF unit. These ETF units are then listed and traded in an exchange. The outstanding ETF units are not limited. Hence, new units can be created by the same process and redeemed in exchange of ETF units to underline shares.
Whereas, in mutual funds, the process is much simpler as compared to ETF. When new investments are done on any fund, new units are created by purchasing the underlying shares. New units are issued to the investors and during the liquidation of investment underlying stocks are sold to pay the investor.
2. Approach to Investment
ETFs are passively managed fund traded on an exchange as a common stock. Their price discovery is done in real time basis. Buying and selling of ETFs is carried throughout the trading session and fluctuations of price is affected by market conditions.
On the other hand, Mutual Funds are both actively and passively managed funds. The price of the fund or NAV is determined after the close of market. New investment in mutual funds is executed at a previous day’s NAV. The effect of market volatility on the fund can only be known after the close of the market.
3. Holding period
As ETF’s are traded on an exchange, it can be traded for intraday positions and short positions can also be executed. There is no specific holding period for ETFs. One can trade in ETFs and invest for long term period also.
Mutual Funds are designed for long term investment purpose and wealth creation in a disciplined fashion. Investment period in mutual fund depends on the financial goals of the investor and investment objective of the fund. Further, an investment in mutual funds is available from short term to long term period. There is no lock-in period for investing in mutual funds.
4. Transaction fees and Charges
Investing in ETF does not include any entry or exit load. The only brokerage charges are applied on the investment just like any common stocks. The expense ratio on ETF funds ranges from 0.1-0.5% which is adjusted to the price.
Investing in Mutual funds does not have any entry charges. But if the investment is liquidated within stipulated time (most one year for equity funds) exit load is charged on the investment in the range of 0.5-1%. Expense ratio for actively managed funds are between 1.5%-2.5% only.
5. ETF and Mutual fund Taxation
For ETFs the tax structure has been summed up in this table:
| Parameter | Index ETF | Gold ETF | Sectoral ETF | International ETF |
|---|---|---|---|---|
| Wealth Tax | Nil | Nil | Nil | Nil |
| Short Term Capital Gains Tax | 15% | As per the Income Tax Slab | 15% | As per the Income Tax Slab |
| Long Term Capital Gains Tax | Nil | 10% without indexation or 20% with indexation | Nil | 10% without indexation or 20% with indexation |
| Securities Transaction Tax (STT) | Nil | 0.125% | Nil | 0.125% |
For Mutual funds tax obligation on investment in equity funds (those fund with the equity portfolio of more than 65%) for the period of more than one year i.e. Long term Capital Gain arises. From 1st April 2018 LTCG of greater than Rs.1 lakh p.a. is subject to tax @ 10% without indexation. While STCG i.e. gain on investment held for less than 1 year is taxed 15% short-term capital gains tax.
For Debt fund, investment for a period of below 3 years is considered short term and taxed @ 10% only. While for LTCG on debt funds held more than 3 years, it is taxed 20% with the benefit of indexation.
6. Minimum Investment amount
Minimum investment amount for ETF is Rs 10000. After the ETF is listed on an exchange, investors can buy or sell additional units only through the recognized stock exchange. Investment through Systematic Investment Plan (SIP) is not available for ETFs.
Investment in mutual funds is much more flexible. In mutual funds, investors can opt for a lump sum or Systematic investment plan (SIP). The minimum investment amount required is Rs. 5000 for lump sum and Rs. 500 if opted for SIP which can increase in multiples of Rs 500.
7. Applications of Investment
ETFs can be used in trading strategies and for long term investment. You can have a look at few advantages of ETFs for the different class of traders and investors:
- Retail investors: It allows diversification of portfolio with one single investment. Due to low-cost design, it enhances returns in the long term.
- For Institutional investors: It allows them easy asset allocation, hedging and efficient use of surplus cash.
- For Arbitrageurs: ETF provides them easy and low-cost option to carry out arbitrage between cash market and futures.
Mutual fund’s investment application is wealth creation over the long-term through equity and debt investment managed professionally. So, these are well suited for long term value investors.
ETF vs Mutual fund: Conclusion
To conclude, let’s present the comparison between mutual funds and ETF in a tabular form:
| Parametres | ETF | Mutual Funds |
|---|---|---|
| Management | ETFs are passively manged. ETF tracks their index closely. | Most of the mutual funds are actively managed. Only Index funds are passively manged. |
| Pricing | Pricing of ETF stocks are done on real time basis. | After the close of markets, NAV of the fund is declared. |
| Fees and Charges | No entry/exit load is charged. Only brokerage, management fees and taxes are charged. | Only Management fess is charged. Exit load is charged in case liquidation of investment before stipulated time. |
| Trading Account | Trading account is required to buy/sell ETFs. | No trading account is required. |
| Applications | ETFs can be used for trading strategies, Hedging, Arbitrage. | Investing for long term wealth creation. |
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Now, that you have read the difference between ETFs and mutual funds, which one do you prefer? Whichever way you invest, just make sure to do thorough research on different investment options in India.