Investors are often faced with a wide array of choices. From stocks and bonds to selecting from different sectors and industries, it can get tricky to make the right pick. Exchange traded funds (ETFs) and mutual funds are two popular investment options that are created from the concept of pooled fund investing. They each have their advantages and disadvantages.
This article helps you understand both investment options and their differences.
What is a mutual fund?
Mutual funds are professionally managed investment funds that trade in diversified holdings. Professionals with advanced skills and knowledge invest the funds which are pooled from various investors into a different class of assets. Mutual fund investments can be made into bonds, stocks, money market instruments or a combination of all. There are three main types of mutual funds – equity funds, debt funds also known as liquid funds, and balanced funds.
What are Exchange Traded Funds?
As the name suggests, ETFs are investment funds that trade on the stock exchanges similar to common stocks. The assets held under ETFs are bonds, stocks and commodities. ETFs can be used for hedging, arbitrage and raising cash.
ETF v/s Mutual funds
Both ETFs and mutual funds allow you to buy a basket of securities within one investment security. However, there are many differences between the two. Let us have a look.
- Mutual funds are traded at the closing net asset value (NAV). However, ETFs are traded during the course of a trading day, and its value can vary during this time.
- Operating expenses of mutual funds can vary based on the type of mutual fund. Mutual fund companies require money to be spent on analysts, company visits, economic and industry research and other such factors making their operating expenses higher. Whereas, ETFs have lower operating expenses as compared to mutual funds because they are passively managed.
- You can only purchase mutual fund shares directly from the fund at a fixed NAV price. On the other hand, you can buy or sell ETFs anytime on the stock exchange, at the prevailing market price.
- Generally, when mutual fund shares are bought or sold the transaction costs are zero. On the contrary, for ETFs, there is an additional cost involved while trading known as the “bid-ask spread”.
- Mutual funds have lower liquidity in comparison to ETFs. ETFs enjoy better liquidity because they are not connected to a daily trading volume. Their liquidity is related to the liquidity of the stocks included in the index.
- Some mutual funds levy a penalty if you sell your shares early. Usually, a time limit imposed on selling a stock is 90 days from the date of purchase. In the case of ETFs, there is no minimum holding period, and you can buy or sell at any point of the trading day at the prevailing market price.
- Fund managers actively manage mutual funds, and they can track indexes. Fund managers pick the assets in a way that it beats the index and achieves a higher performance. Whereas, in the case of ETFs, fund managers try to match the price movements of an index and the returns by assembling a portfolio which can match the index constituents as closely as possible.
For building a diversified portfolio, ETFs and mutual funds can be complementary to each other. Each of the instruments can meet specific needs and help you accumulate long-term wealth. While ETFs can appeal more to index fund investors, mutual funds can offer a more comprehensive selection of actively managed funds.