When you consider safe investment option, a comparison between ETF vs mutual fund comes.
This is because both ETF and mutual funds have cardinal features that help investors.
From low risk to lower transaction expenses, there are many benefits.
But then the question is if both deliver investor concerns, how are they different?
Well when you compare ETF vs mutual fund, the difference is primarily in concept.
The structure is also very different.
Most importantly, though they both derive value from underlying assets, the calculation differs.
There is also a relative ease of use element in the whole deal.
While the ETF is the comparatively new kid on the block, mutual fund is more traditional.
While everyone knows MFs as a safe investment instrument, ETFs are slowly gaining popularity.
The low cost and better tax treatment are the key reasons for ETF scoring over mutual funds at times.
A designated Fund Manager chooses them after thorough analysis.
ETFs are also a pool or a basket of investment assets.
But the benefit is this one does not have load costs and operating costs are also lower.
Often these minor differences together make for a winning combination.
In fact, when you compare ETF vs mutual fund, the most important factor is your objective.
Often the kind of targets that you have set or the extent of returns you expect determines what’s better.
In many ways, the difference between the two is often the different type of investors.
The country where they are investing, and the economic situation also makes a difference.
Most importantly the basket of assets that you choose is crucial.
Sometimes the extent of gains is dependent on that aspect most importantly.
ETF vs Mutual Fund Structure
When you compare ETF vs mutual fund, you must analyze the fund structure.
Each of these has a pre-determined format that they operate in.
On an average, there are two types of mutual fund.
1. Open Ended Funds
These are one of the most common types of mutual fund world over.
Both in terms of volume and the total assets they manage, they are key players in the market.
As the name indicates, there is a direct transaction in case of this type of mutual fund.
There is direct buying and selling without the role of any person in the middle.
The fund can issue unlimited shares in this case.
These funds are marked to market.
It means these need regular valuation as per Government norms.
Though this impacts the share price, the value of an investor’s share remains unaffected.
This is irrespective of the outstanding shares that are available on an average.
2. Close-Ended Funds
This is another common type of mutual funds that are available.
There is no new share issuance in this case.
As a result, the price is completely driven by investor demand.
More than the net asset value, it is the investor interest that has a bearing on the prices.
Most times, the share price operates either at a premium or significant discount.
The ETF structure varies significantly.
1. ETF Unit Investment
They try to replicate the indices that mirror as closely as possible.
However, there is no auto-reinvestment of the dividend.
Instead, they pay cash dividend to investors each quarter.
2. Index ETF Mutual Fund
In this case, the dividend is reinvested.
Shareholders get payment on a quarterly basis.
3. Grantor Trust
In many ways, this is similar to close-ended mutual fund.
But the investors here have voting rights.
In this case, also the dividends are not reinvested but paid directly to investors.
ETF Has Lower Fees Compared to Mutual Fund
The load expense is the most pertinent difference when you compare ETF with mutual fund.
The load fee is undeniably one of the biggest charges associated with mutual funds.
The Load fees for mutual funds can range between 3-9% even.
While some mutual funds try marketing their products as commission-free, it is only a gimmick.
While it can be a great promotional concept, the load fees go on to serve the same purpose.
Essentially, the investor has to pay the broker a percentage of their investment.
So in a way, it becomes a compensation for the broker who is managing or selling the product.
Different mutual fund charges the load fees at the different time.
There are some which are front-ended, so you need to pay the fees upfront.
There are other back-ended options too.
In this case, the fee is charged during redemption.
So whether you pay it while buying it or redeeming the mutual fund, you will have to pay it.
But the ETFs don’t come with any associated load fees.
These operate more like stocks, and you have to pay brokers a commission for it.
These commissions are normally pre-decided and not levied on a percentage basis.
On an average, they range around $8-10.
The problem is if you trade these ETFs very often, the commission amount can add up.
But in case you buy a big stake or hold for a longer duration, it can neutralize or become cheaper.
On an average, any investment in ETF works out much cheaper.
Of course, this needs to be calculated both as per returns and total time duration.
The expense is also directly related to the choice of funds too.
There are some which will work out cheaper compared to others.
When you compare ETF with mutual fund, transparency is a key factor.
Almost inevitably with a mutual fund, you are at the Fund Manager’s mercy.
You only decide on a specific fund.
You have no role in deciding the components or even the way the fund is managed.
The ETF is relatively a more transparent investment instrument.
You can easily verify your account on a day to day basis and take a call.
As per regulation, a mutual fund needs to disclose portfolio just every quarter.
A day to day monitoring is not possible.
In between a quarter, an investor has no idea about how much or what was invested.
So you are never sure if the fund manager risked more than they are supposed to.
This is never the case with exchange-traded funds.
So you manage your ETF portfolio more actively.
But in case of the mutual fund, you may also have to be prepared for any negative impact.
Supposing the fund manager’s strategy does not play out as planned, your net worth can suffer in case of MFs.
It is more like taking a plunge in the dark.
This problem is completely addressed in case of ETFs.
They disclose their positions publicly every day.
That makes it a far more trustworthy instrument for investors.
On an average, most ETFs have relatively high disclosure norms.
As a result, investors are more in control of their investment.
It is easier for them to take note of the daily dealings.
So even if they want to book profit somewhere mid-way, it is much simpler.
So even judging by the law of the land, the ETF has much better transparency.
Daily disclosures are mandatory.
mutual funds do not have any such regulatory requirement.
Fund managers have a much greater say.
The tax efficiency of an investment instrument is very important.
It helps determine an investment’s appeal for investors.
Moreover, saving tax is also seen as a motivation for meaningful savings.
In this case, when you compare ETF vs mutual fund, ETFs win hands down.
The tax efficiency of ETFs is also because of the way they are created.
On an average, ETFs are primarily index funds, so the turnover is much lesser.
The actively managed mutual funds relatively record a much higher degree of turnover.
As a result, the ETFs are way more tax efficient.
When a mutual fund investors look to redeem funds, the fund has to sell securities.
They can only raise cash through this securities sale.
But in case of an ETF, it is straightforward and direct like share sale.
One investor sells the ETF to another.
There are no capital gains in the process, hence no tax liability either.
This direct sale ensures the least amount of transaction expenses.
As you can see, this has a positive impact on the overall pricing.
So the ETF investor earns significantly higher returns after tax compared to mutual funds.
But this is just a general case analysis.
There are many exceptions.
Though on an average, ETFs are tax efficient, there are some complicated variants too.
Similarly, there are many mutual funds that have unique tax advantage.
But that said, you cannot escape the higher capital gains expenses in case of MFs.
These go on to increase the tax liability of this instrument on an average.
By the same laws of average, ETFs score much higher.
On most of the index based plays, they give investors better returns.
Moreover, an ETF is predominantly passively managed fun.
In comparison, mutual funds can be either passively managed or even active funds too.
This is another common point of comparison between ETF and mutual fund.
Often the level of liquidity also determines the efficiency of an instrument.
It goes on to highlight the key to investor savings.
A well-managed fund always exhibits excellent liquidity condition.
Often the liquidity and volume are parameters to determine a good fund from a bad one.
It also goes on to highlight the core construct of the fund and overall success rate.
In this context, most broad-based ETFs exhibit significant liquidity.
These are high volume counters traded quite extensively across investor groups.
However, that’s true about the Index ETFs.
Needless to mention, these are the most common types of ETFs available.
However, there can some niche options like country specific.
Or there are many with the lesser number of assets too.
These ETFs are thinly traded counters and can have very low liquidity in general.
So when you are choosing an ETF, you must consider the market cap of the underlying asset.
Only if these exhibit strong valuation, you should choose such an ETF.
The valuation and liquidity in case of mutual fund vary to a large extent.
Normally mutual fund liquidity may comprise of all cash or a mix of cash and cash equivalent.
Normally they declare a mutual fund liquidity ratio.
This goes on to highlight the extent of cash assets for a specific fund.
Most times the liquidity levels of a mutual fund is also a key signal for market direction.
Investor interest in the mutual fund is gauged as a positive in terms of an up-move in the market.
At the same time, low mutual fund liquidity can warn the market of a potential storm brewing.
The average mutual fund liquidity ratio may hover close to the 3% mark across markets in general.
Active: Passive Management of Funds
This is another key point when you compare ETF vs mutual fund.
You have different types of mutual funds.
Some track the index while there are others for the sectors.
There are many that offer a healthy mix of assets.
But almost always these funds are actively managed.
The fund manager is constantly juggling assets.
The whole idea is to generate higher returns than the benchmark index.
Therefore, the fund manager has to constantly work around permutation and combination.
This is done with the primary motive to raise the relative return from these instruments.
In comparison, most ETFs are passively managed funds.
They almost always track a specific index and try to match the rates as per that.
The portfolio in many ways mirrors the index your fund is tracking.
As a result, the elements of the fund are very similar to the main index.
They constantly try to match the Index, in terms of returns and relative movement.
As a result, they do not need any active intervention.
Thus it becomes a passively managed ETF.
There are some instances of passive mutual funds too.
However, the percentage of those are fairly limited in investment circles.
This is perhaps the biggest point in the difference between ETF and mutual fund.
It highlights the price at which you can close the deal.
It is as important to determine the buying rate as well as the selling price.
In this context, you already know that ETFs trade like the stock market.
This means you can trade the ETF at any point of time and hope to get that rate.
But in comparison, the mutual fund can trade only once a day.
The net asset value is the rate that a mutual fund trades at the end of the day.
The NAV price is what determines the actual worth of the mutual fund.
In comparison, the ETF rate tracks the index that it derives value from.
As an investor, you can choose to redeem your position at point in time.
Therefore, this instrument invariably determines a far higher rate of return.
Moreover, the relative expense is also much lower.
As a result, investors have greater freedom to redeem any ETF at any time.
However, in case of mutual fund, they have to wait for the market close.
Irrespective of what time they may have redeemed it, they will only get the closing rate.
So sometimes it may work against the investor’s interest.
They may not get the exact amount of interest that they were targeting.
The ETFs have no such problems to deal with.
They can easily be redeemed at any specific time and gives investors a higher degree of flexibility.
Often this flexibility also makes the way more popular.
The mutual fund closing rates in this context are pretty rigid.
They do not consider on a case by case basis.
Investors have to invariably follow one basic blanket rule for all.
Therefore, you can conclude that there are extensive similarities and difference between ETF and mutual fund.
While the mutual fund is a more conventional mode of investment, ETF is modern.
The rate of return is higher in most ETFs due to tax arrangements.
However, mutual fund provide a basic minimum guarantee in return of the commission.
On an average the mutual funds and ETFs vary primarily on the point of operation.
This why there is a huge difference in return even if they track the same index.
So as an investor you have to decide on your investment objective and target very carefully.
That will help you to choose confidently between an ETF and mutual fund.