Difference Between ETFs and Mutual Funds

Investing in the financial markets can feel overwhelming, especially with so many options available. If you’re an Indian investor looking to grow your wealth, you’ve likely come across terms like ETFs and mutual funds. Understanding the difference between ETFs and mutual funds is crucial to making informed investment decisions.

What Are ETFs and Mutual Funds?

Before diving into the difference between ETFs and mutual funds, let’s first understand what they are.

What Are ETFs?

Exchange-Traded Funds (ETFs) are investment funds that trade on stock exchanges, just like individual stocks. They typically track an index, such as the Nifty 50 or Sensex, and aim to replicate its performance. For example, a Nifty 50 ETF will hold the same stocks as the Nifty 50 index in the same proportions.

ETFs are popular because they offer diversification, low costs, and the flexibility to buy or sell shares throughout the trading day. In India, ETFs are gaining traction, with options like the Nippon India ETF Nifty BeES being widely traded.

What Are Mutual Funds?

Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. They are managed by professional fund managers who make investment decisions on behalf of investors. Mutual funds in India are offered in various categories, such as equity, debt, and hybrid funds, catering to different risk appetites.

Unlike ETFs, mutual funds are typically bought or sold at the end of the trading day at their Net Asset Value (NAV). Popular mutual funds in India include those from SBI Mutual Fund, HDFC Mutual Fund, and ICICI Prudential.

Now, let’s explore the difference between ETFs and mutual funds in detail to help you decide which is better for you.

Key Differences Between ETFs and Mutual Funds

The difference between ETFs and mutual funds lies in their structure, trading mechanism, costs, and management style. Below, we break down these differences to make it easier for Indian investors to understand.

1. Trading Mechanism

One of the primary differences between ETFs and mutual funds is how they are traded.

• ETFs: ETFs are traded on stock exchanges like the BSE or NSE throughout the trading day. You can buy or sell ETF shares at real-time market prices, similar to stocks. This gives investors the flexibility to react to market movements instantly. For example, if you want to invest in a gold ETF, you can purchase it during market hours at the current price.
• Mutual Funds: Mutual funds are not traded on stock exchanges. Instead, you buy or sell units directly through the fund house or a distributor at the day’s closing NAV. This means you can’t take advantage of intraday price movements, which can be a drawback for active investors.

2. Cost Structure

Cost is a critical factor when comparing the difference between ETFs and mutual funds. Generally, ETFs are more cost-effective, but let’s look at the specifics.

• ETFs: ETFs typically have lower expense ratios because they are passively managed and track an index. For instance, the expense ratio of a Nifty 50 ETF might be as low as 0.05% to 0.2%. However, you may incur brokerage fees and a Demat account maintenance charge since ETFs require a Demat account for trading.
• Mutual Funds: Mutual funds, especially actively managed ones, have higher expense ratios, often ranging from 0.5% to 2.5%. This is because they involve active management by fund managers who research and select securities. Even low-cost direct plans of mutual funds tend to have higher fees than ETFs.

3. Management Style

The difference between ETFs and mutual funds also extends to how they are managed.

• ETFs: Most ETFs in India are passively managed, meaning they aim to replicate the performance of an index like the Nifty 50 or Sensex. The fund manager’s role is minimal, as the ETF simply holds the same securities as the index it tracks. This reduces management costs and human error.
• Mutual Funds: Mutual funds can be actively or passively managed. Actively managed funds rely on fund managers to select stocks or bonds to outperform the market, which increases costs. Passively managed mutual funds, also called index funds, are similar to ETFs but still have slightly higher expense ratios.

4. Minimum Investment

The difference between ETFs and mutual funds in terms of minimum investment can influence your choice, especially if you’re a beginner.

• ETFs: ETFs allow you to invest with as little as the price of one share, which can be as low as ₹100 for some ETFs in India. However, you need a Demat account and a trading account, which may involve additional costs.
• Mutual Funds: Mutual funds often have a minimum investment requirement, such as ₹500 or ₹1,000 for lump-sum investments or Systematic Investment Plans (SIPs). This makes mutual funds more accessible for investors without a Demat account.

5. Liquidity

Liquidity is another area where the difference between ETFs and mutual funds becomes evident.

• ETFs: ETFs offer high liquidity because they can be traded throughout the day on stock exchanges. However, the liquidity of an ETF depends on its trading volume. Popular ETFs like the SBI ETF Gold have high liquidity, while niche ETFs may have lower trading volumes.
• Mutual Funds: Mutual funds are less liquid because you can only buy or sell units at the end of the trading day. However, redemption is straightforward, and you can expect to receive your money within a few days, depending on the fund type.

6. Taxation

Taxation is an important consideration for Indian investors when evaluating the difference between ETFs and mutual funds.

• ETFs: Equity ETFs are taxed like equity shares. If held for more than a year, long-term capital gains (LTCG) above ₹1 lakh are taxed at 10%. Short-term capital gains (STCG) for holdings less than a year are taxed at 15%. Debt ETFs follow different tax rules, with gains taxed as per your income tax slab.
• Mutual Funds: Equity mutual funds follow the same tax rules as equity ETFs. For debt mutual funds, LTCG (held for over 3 years) is taxed at 20% with indexation, while STCG is taxed as per your income tax slab.

7. Transparency

Transparency is another factor in the difference between ETFs and mutual funds.

• ETFs: ETFs are highly transparent because their holdings are disclosed daily. You can easily check the stocks or assets an ETF holds, making it easier to understand where your money is invested.
• Mutual Funds: Actively managed mutual funds disclose their holdings monthly or quarterly, which is less frequent than ETFs. This can make it harder to know exactly what the fund is investing in at any given time.

8. Flexibility

The difference between ETFs and mutual funds also lies in the flexibility they offer.

• ETFs: ETFs provide greater flexibility because you can trade them like stocks, use stop-loss orders, or even short-sell in some cases. This makes them suitable for both long-term and short-term investors.
• Mutual Funds: Mutual funds are less flexible as they can only be bought or sold at the day’s NAV. However, they offer features like SIPs, Systematic Withdrawal Plans (SWPs), and Systematic Transfer Plans (STPs), which are ideal for disciplined, long-term investing.

Benefits of ETFs

To further clarify the difference between ETFs and mutual funds, let’s look at the advantages of ETFs:

• Low Costs: ETFs generally have lower expense ratios, making them cost-effective for long-term investors.
• Intraday Trading: You can buy or sell ETFs at any time during market hours, giving you more control over your investments.
• Diversification: ETFs provide exposure to a wide range of assets, reducing risk through diversification.
• Transparency: Daily disclosure of holdings ensures you know exactly what you’re investing in.
• Variety: In India, ETFs are available for equities, debt, gold, and even international indices, offering plenty of choices.

Benefits of Mutual Funds

Mutual funds also have unique advantages that highlight the difference between ETFs and mutual funds:

• Professional Management: Actively managed mutual funds are handled by experts who aim to outperform the market.
• Accessibility: No need for a Demat account, making mutual funds easier to start with for beginners.
• SIP Options: Mutual funds allow you to invest small amounts regularly through SIPs, promoting disciplined investing.
• Variety of Options: From equity to debt to hybrid funds, mutual funds cater to diverse risk profiles and goals.
• Redemption Ease: Redeeming mutual fund units is straightforward, with funds credited to your account within days.

Drawbacks of ETFs

While ETFs have many benefits, they also have some limitations that contribute to the difference between ETFs and mutual funds:

• Demat Account Requirement: You need a Demat and trading account to invest in ETFs, which adds to the cost.
• Brokerage Fees: Every ETF transaction incurs brokerage fees, which can add up for frequent traders.
• Limited Active Management: Most ETFs are passively managed, so they may not outperform the market.
• Liquidity Issues: Some ETFs, especially niche ones, may have low trading volumes, making it harder to buy or sell.

Drawbacks of Mutual Funds

Mutual funds also have their downsides, further emphasizing the difference between ETFs and mutual funds:

• Higher Costs: Actively managed mutual funds have higher expense ratios, which can eat into your returns.
• Less Flexibility: You can only buy or sell at the day’s NAV, limiting your ability to react to market changes.
• Management Risk: The performance of actively managed funds depends on the fund manager’s expertise, which can vary.

Which Is Better: ETFs or Mutual Funds?

The difference between ETFs and mutual funds means that the better option depends on your financial goals, risk tolerance, and investment style. Here’s a quick guide to help you decide:

• Choose ETFs if:
  • You want low-cost, passive investments.
  • You prefer the flexibility of intraday trading.
  • You have a Demat account or are comfortable opening one.
  • You’re looking for transparency and diversification.
• Choose Mutual Funds if:
  • You’re a beginner who wants to start with SIPs.
  • You don’t have or want a Demat account.
  • You prefer professional management to potentially outperform the market.
  • You want a disciplined, long-term investment approach.

For Indian investors, a combination of both ETFs and mutual funds might work best. For example, you could invest in a Nifty 50 ETF for low-cost, broad-market exposure and complement it with an actively managed equity mutual fund for potential outperformance.

How to Invest in ETFs and Mutual Funds in India

To invest in ETFs, you’ll need a Demat and trading account with a broker like Zerodha, Upstox, or Groww. Once set up, you can search for ETFs on the BSE or NSE and place buy or sell orders during market hours.

For mutual funds, you can invest directly through the fund house’s website, via platforms like Groww or Paytm Money, or through a distributor. You can start with a lump-sum investment or set up a SIP for regular contributions.

Always research the fund’s performance, expense ratio, and suitability for your goals before investing. Consulting a financial advisor can also help you navigate the difference between ETFs and mutual funds and build a balanced portfolio.

Common Misconceptions About ETFs and Mutual Funds

Let’s clear up some myths that add to the confusion around the difference between ETFs and mutual funds:

• Myth 1: ETFs are always cheaper than mutual funds. While ETFs generally have lower expense ratios, brokerage fees and Demat account charges can add up, making them costlier for frequent traders.
• Myth 2: Mutual funds always outperform ETFs. Actively managed mutual funds aim to beat the market, but many fail to do so consistently, especially after accounting for fees.
• Myth 3: ETFs are only for experienced investors. ETFs are simple to understand and can be suitable for beginners, provided they have a Demat account.
• Myth 4: Mutual funds are always safe. The safety of mutual funds depends on the type (equity, debt, etc.) and market conditions, just like ETFs.

FAQs

Conclusion

Understanding the difference between ETFs and mutual funds is essential for Indian investors looking to build wealth. ETFs offer low costs, flexibility, and transparency, making them ideal for those who want to trade like stocks and track indices. Mutual funds, on the other hand, provide professional management, accessibility, and disciplined investing options like SIPs, catering to beginners and long-term investors.

By evaluating your financial goals, risk tolerance, and investment preferences, you can decide whether ETFs, mutual funds, or a mix of both is right for you. Always research thoroughly and consider consulting a financial advisor to make the most of your investments. With this knowledge of the difference between ETFs and mutual funds, you’re better equipped to navigate India’s financial markets and achieve your wealth-building goals.

Disclaimer: Moneyjack.in provides general financial information for educational purposes only. We are not financial advisors. Content is not personalized advice. Consult a qualified professional before making financial decisions. We are not liable for any losses or damages arising from the use of our content. Always conduct your own research.