In the ever-evolving landscape of investment vehicles, Mutual Funds and Exchange-Traded Funds (ETFs) stand as two prominent choices for investors seeking diversification and growth. However, they operate under different investment strategies and possess unique benefits and limitations.
By exploring the nuances between mutual funds and ETFs, you can gain clarity on how each aligns with your investment objectives and risk tolerance levels. This article aims to explore the key differences between mutual funds and ETFs, providing insights to assist you in making informed decisions for your financial future.
What are Mutual Funds and how do they function?
Mutual funds pool money from different investors and invest it in a portfolio of market-linked instruments such as stocks, bonds, money market instruments, gold, etc. Essentially, they offer a channel for investing in diverse avenues. Each mutual fund has a unique investment objective and is managed by professional fund managers who are experts in analysing and managing investments to optimise returns and minimise risks. Investors are allotted units in proportion to their holdings in the overall investments. These units are priced at the net asset value (NAV), which is computed on a daily basis.
Types of Mutual Funds
Based on Structure
- Open-ended funds: Investors enjoy flexibility in investing in or redeeming units at any time.
- Closed-ended funds: Investors can invest only during the new fund offer (NFO) launch, with a lock-in period restricting unit redemption until maturity. Despite this, closed-ended funds are listed on stock exchanges, allowing investors to sell units before maturity if necessary.
Based on Asset Class
- Equity funds: Aim at wealth creation by investing in stocks, suited for aggressive investors targeting long-term objectives..
- Debt funds: Invest in fixed-income securities for stable income, appealing to conservative investors.
- Hybrid funds: Invest in a mix of stocks, fixed-income instruments, gold, etc., to leverage diversification across multiple asset classes, suitable for moderate risk appetites.
Based on Investment Style
- Active funds: Fund managers actively make buy and sell decisions aiming to outperform benchmarks.
- Passive funds: Follow a passive investment strategy, aiming to replicate benchmark performance. Index funds and ETFs fall under this category.
What are ETFs and how do they function?
Exchange-Traded Funds (ETFs) are indeed a type of Mutual Fund, as both gather funds from investors and invest in a portfolio of securities. However, the crux of the ETF vs. Mutual Fund comparison lies in their structure and operation.
Mutual funds are actively managed investments, with a fund manager actively making buy and sell decisions after analysing companies and markets. Their goal is to achieve superior returns compared to their benchmark. In contrast, ETFs are passively managed funds aiming to replicate the performance and portfolio of a specific index.
ETF creation and redemption
The unique creation and redemption process of ETFs involves large Authorised Participant (a market maker or an institutional investors), facilitating the exchange of shares for baskets of underlying assets, and aiding in maintaining price alignment with the fund’s NAV.
For instance, if an ETF aims to follow the Nifty, the Authorised Participant purchases all 50 stocks in the index with the same weights. Then, the AP gives these 50 shares to the ETF provider. In exchange, the AP receives a 'creation unit' – a bundle of ETF shares worth the same value.
Creation entails buying all underlying securities and combining them into the ETF structure, while redemption involves separating the ETF into its individual securities.
Types of ETFs
ETFs span various asset classes:
- Index ETFs: These ETFs aim to replicate the performance of a specific index, such as the Nifty 50, Nifty 500 etc. providing broad market exposure.
- Sector-Specific ETFs: Targeting specific sectors of the economy, like technology, healthcare, or finance, these ETFs allow you to focus on industries you believe will outperform.
- Thematic ETFs: Built around specific themes or trends, such as ESG (Environmental, Social, and Governance) criteria, PSU, infrastructure, digital theme.
- Fixed Income ETFs: Designed for investors seeking steady income, these ETFs invest in bonds, including government, corporate, or municipal bonds.
- Commodity ETFs: These ETFs provide exposure to commodities, such as gold and silver, without the need to physically hold the commodity.
Key differences between ETF and Mutual Fund
Investment approach
Mutual funds often offer active management, wherein fund managers make decisions on asset allocation to potentially outperform the market. This can potentially yield higher returns but at a higher cost. ETFs, on the other hand, are primarily passive investments aiming to mirror the performance of an index. They provide a lower-cost investment option but with limited potential for outperforming the market.
Liquidity
ETFs are traded on exchanges, meaning you can buy and sell them on a real-time basis like a stock. This allows investors to respond swiftly to market changes, making ETFs appealing to those seeking more control over their investment timing. In contrast, mutual funds are typically bought or sold at the end of the trading day at the NAV.
Cost structure
ETFs are generally known for their lower expense ratios compared to mutual funds, primarily due to their passive management style, which typically tracks a specific index. On the other hand, Mutual funds might have higher expense ratios due to associated with research, analysis, and active trading.
Minimum investment
Mutual funds commonly have a minimum investment threshold. ETFs, on the other hand, can be bought like a share, offering a more accessible entry point for investing.
Lock-in period
ETFs typically have no lock-in period, allowing you to buy and sell them at your convenience. Similarly, most mutual funds also don’t have a lock-in period, except in the case of closed-ended funds and ELSS (Equity Linked Savings Scheme). However, many mutual funds charge an exit load if units are redeemed within a specified time period of investment, effectively acting as a lock-in period. The objective of the exit load is to discourage investors from redeeming within a short period.
Also Read: Cultivate wealth wisely: A guide to nine tax-efficient investment options
Conclusion
To choose the right investment for you, it's important to grasp the main difference between ETFs and Mutual Funds. Mutual funds are actively managed funds aiming to beat their benchmark. This means that the choices made by a fund manager regarding stocks and sectors greatly affect their performance. Remember, the potential for higher returns usually comes with higher risks and costs. On the flip side, ETFs are low-cost, passively managed funds suited for those who take moderate risks, as they're typically less volatile than actively managed funds.
Axis Bank offers an extensive selection of Mutual Funds, catering to your diverse investment strategies and goals. Dive into our range of investment products and discover how we can help you achieve your financial aspirations with tailored solutions.
Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. T&C apply.
