ETF vs Mutual Funds: Understanding the differences between ETFs and mutual funds is crucial for choosing the best option based on your investment strategy and risk tolerance. To help you make an informed decision, this article compares the characteristics of both investment methods. Let’s take a look.
Investing in the financial markets often begins with understanding two fundamental approaches: mutual funds and ETFs. At first glance, both are pooled investment schemes that collect money from multiple investors and invest it in a diversified portfolio of securities.
However, they differ significantly in their operational mechanisms, investor accessibility, cost structures, and trading dynamics.
These differences matter because they determine the flexibility, costs, tax treatment, and suitability for investors based on their investment goals. Many of us get confused about how they actually work. So, let’s understand the real differences between them.
ETF vs Mutual Funds: Understanding Mutual Funds
Mutual funds have been a mainstay of retail investing for several decades. A mutual fund is an investment vehicle where a large number of people pool their money together, and it is managed by a professional fund manager working through an Asset Management Company (AMC).
The primary objective is to buy a diversified portfolio of stocks, bonds, or other investments and attempt to achieve the investment goals, whether it’s growth, income, or capital preservation.
In India, mutual funds are regulated by SEBI (Securities and Exchange Board of India), and most mutual funds are actively managed: that is, their fund managers make buying/selling decisions based on their research, market forecasts, etc.
Passive versions also exist (for example, index funds), although traditionally, most mutual fund investments are made through actively managed schemes, where the fund manager attempts to outperform a benchmark index.
ETF vs Mutual Funds: Understanding Exchange-Traded Funds
On the other hand, an Exchange Traded Fund (ETF) is a type of fund that holds a portfolio of assets such as equities, government bonds, commodities, or other financial products related to a specific index, and accordingly, aims to replicate the performance of a particular benchmark index, rather than trying to outperform it.
In most cases, an ETF is a passively managed fund, and its primary objective is to mirror the performance of its underlying index. Taking the Nifty 50 ETF as an example, it would hold equities representing a specific composition of the Nifty 50, allowing it to deliver returns closely tracking its performance.
SEBI (Securities and Exchange Board of India) considers ETFs to be part of the mutual fund framework; however, unlike other mutual funds, ETFs are traded on stock exchanges like equities, giving their users the characteristics of a stock.
ETFs vs. Mutual Funds: Key Differences
The most basic difference between these investment options lies in how they are bought and sold.
1. In mutual funds, investments are made at the Net Asset Value (NAV), which is determined at the end of the trading day. Investors submit their investment requests during the day through the internet, brokerage houses, or the AMC (Asset Management Company) and receive the NAV at the end of the day. ​​Trading in mutual funds cannot be done throughout the day because the price does not fluctuate during the day.
2. ETFs can be bought and sold throughout the trading day according to stock exchange rules and based on market supply and demand. Because they are listed on the stock exchange, there may be a slight difference between the NAV and the stock price during the trading day due to market forces.
3. Another important area of ​​difference is the cost structure. ETFs are comparatively cheaper in terms of expense ratios due to passive management. ETFs do not involve extensive investment research or management costs. Consequently, the expense ratios are comparatively lower, meaning investors will realize higher returns on their investments in ETFs.
4. Mutual funds, especially actively managed funds, are more expensive due to management fees, administrative charges, and sometimes entry or exit fees. Although the charges are regulated by SEBI, overall, the cost difference between funds is significant, particularly for actively managed funds.
5. Another difference between mutual funds and ETFs from an organizational or structural perspective relates to the minimum investment and required accounts.
6. Mutual funds have a minimum investment limit, which is set at a fixed amount, such as ₹500 or more, either as a lump sum or through SIPs. SIPs are a very common method with mutual funds, where people invest a fixed amount at regular intervals, focusing on disciplined investing.
7. In ETFs, the required minimum investment is essentially the price of one unit of that ETF; therefore, their minimum investment cost is very low.
8. In terms of liquidity and transparency, there are some differences. ETFs have better real-time liquidity because they are listed on the stock exchange, meaning all investors have access to real-time prices, and all transactions are also completed instantly.
9. In mutual funds, transactions are settled at the end of the day through the NAV system and do not have real-time pricing. Another difference is that mutual funds disclose information about their holdings on a monthly or quarterly basis, while ETFs list them daily.
10. The taxation system for equity ETFs and equity mutual funds in India is largely the same: Long-term capital gains (LTCG) on equity holdings held for more than a year are taxed at 10 percent above the exemption limit, while the rate for short-term gains is 15 percent. For other funds, the rates vary depending on the holding period.
The most important thing to understand about equity ETFs is that they are instruments listed on the stock exchange; therefore, when units are sold, a taxable event occurs at the time of the transaction, just like when mutual fund units are sold.
ETFs vs. Mutual Funds: Conclusion
Both mutual funds and ETFs serve the purpose of diversified investing, but they differ in structure, costs, trading flexibility, and management style. Mutual funds are suitable for investors who prefer professional active management, systematic investing, and end-of-day pricing, while ETFs appeal to those who seek lower costs, intraday liquidity, and passive index-based exposure. The choice between the two depends on an individual’s risk tolerance, investment goals, cost sensitivity, and preference for trading flexibility.
Disclaimer: The above article is meant for informational purposes only, and should not be considered as any investment advice.