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ETFs can be traded on the stock exchange throughout the day, while mutual funds can only be traded on their NAV value once daily after the market closes. Moreover, ETFs have a more passive management style and mirror the index they track, while mutual funds have active fund management and seek to outperform the indexes they track.
ETFs and mutual funds both track indexes and are managed by professionals. They are popular investment tools that allow you to diversify your portfolio and access key aspects of the economy. This allows you to capitalise on any upward mobility as an investor.
While they may operate similarly, they have a few key differences that we will be discussing. So stick around to find out which option you should pick to boost your returns this year.
Understanding ETFs and Mutual Funds
ETFs
Exchange-traded funds or ETFs are a type of index fund that can be traded on a stock exchange like regular stocks2. An ETF provider will offer a basket of securities/assets like equities, stocks, bonds, commodities, or currencies - each with its own ticker.
You can buy a share in that basket like you can buy a stock from a company/firm, and like a regular stock, you can trade the ETF on an exchange throughout the day to take advantage of market fluctuations.
Mutual Funds
They are trusts that collect money from investors and invest it into equities, debt, government securities, and other money market instruments to accumulate interest over time.
Difference Between ETFs and Mutual Funds
Parameters |
Exchange-Traded Funds (ETFs) |
Mutual Funds |
Trading and Liquidity |
ETFs are traded like regular stock on the stock exchange, where prices fluctuate throughout the day. Hence, they have higher liquidity. |
Can only be bought and sold once per day at the Net Asset Value (NAV) price after the market closes. So, lower liquidity than ETFs |
Transaction Cost |
Additional implicit costs like bid-ask spread when trading ETFs. |
Almost zero when shares are bought and sold. |
Expense Ratio |
Lower management fees |
Higher management fees |
Investment Approach |
Passive. They track/mirror a specific index and seek to match its returns. |
Actively managed. They seek to outperform the index they track. |
Minimum Investment |
Do not have a minimum amount since they trade like stocks |
Have a set currency amount/value. |
Taxation* |
Lower capital gains tax |
Higher capital gains tax |
Diversification |
Offer more targeted investments that mirror a chosen index. |
Offer more portfolio diversification options and exposure to a broader range of assets and securities. |
Lock-In Period |
No lock-in period. |
Most do not, but ELSS mutual funds have a 3-year lock-in period. |
Demat Account |
Mandatory for stock market transactions |
Not Required |
ETFs vs. Mutual Fund: What is the Difference?
If you do not mind paying a higher fee for the potential of higher returns, mutual funds can be beneficial.
They can also be bought without trading commissions and allow you to automate specific transactions. For example, you can set automatic investments and withdrawals in and out of your account based on your preferences.
However, some mutual funds have a penalty if you sell your shares too early and they tend to be less tax efficient than ETFs as they attract more capital gains tax.
If cost and tax efficiency are important to you - ETFs are more cost-effective and have higher liquidity. They are also suitable if you prefer control over your trade price if you want to take advantage of market fluctuations.
However, ETFs have implicit and explicit costs. The operating expense ratio and trading commission expenses will be disclosed, but you must pay attention to the implicit costs like bid/ask spread and premium/discount to NAV.
The bid/ask spread is built into the market price and paid on each sale. So, the more frequently you trade, the more relevant this cost becomes. Realising small gains or losses from potential changes in discounts and premiums also makes you aware of the risks involved.
ETFs also generally provide lower returns than other types of mutual funds due to how they operate. Therefore, ETFs have a lower tax liability.
Conclusion
Overall, ETFs and mutual funds are less risky than investing in individual stocks and bonds. Mutual funds are the way to go if you want to outperform the market with active management and do not mind paying higher fees for the potential of higher returns.
If a passive management style, tax efficiency, and low expense ratios are a priority, and you can accept whatever returns the index offers, ETFs are perfect.
Most investors today prefer to invest small amounts in both and other investment plans to ensure they have a diverse portfolio and maximise their returns. This approach also provides more cushioning against market fluctuations and protects your portfolio against major losses.
