Mutual Funds Vs. ETFs: Where to invest?

Should you be investing in Mutual funds or Exchange Traded Funds(ETFs)? Check out what is good for you.

Mutual Funds V/s Exchange Traded Funds

 

The most preferred route for investing in equities is either Mutual Funds (MFs) or Exchange Traded Funds (ETFs) depending upon your objective of the investment,

You can choose mutual funds if you are looking to beat index returns, on the other hand, you can choose ETFs if you are looking for passive investing.

Let us first understand how similar and how different ETFs and MFs are.

Understanding ETFs

ETFs (Exchange Traded Funds) is basically an investment fund that is traded on stock exchange. These are passively managed funds which can hold either stocks, bonds or commodities as underlying assets.

Generally, ETFs have higher liquidity and lower expenses as compared to mutual fund units. However, ETFs are traded on exchanges, and their value fluctuates throughout the trading hours.

An ETF investing in commodities may invest in gold, silver etc. An equity-oriented ETF will follow a particular index and will invest only in the stocks comprising that index. For example, Nifty ETF will invest in 50 stocks of the Nifty index. However, the ratio of allocation may be same or varies slightly.

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Debt ETFs or Bond ETFs invest mainly in fixed income securities and invest according to the index it follows. For example, a Debt ETF may follow NIFTY Composite G-Sec Index or NIFTY AAA Corporate Bond Index.

Understanding Mutual Funds

Mutual Funds(MFs) are funds actively managed by professional fund managers. In MFs, funds are pooled from various investors and invested according to the objectives of the fund. MFs can invest in stocks, debt instruments, commodities as well as in a combination of these.

For an equity MF, depending on the objective, the fund manager will invest in stocks across various sectors, varied market capital, and various themes.  The fund manager will always try to beat the benchmark index, to which the fund is aligned to.

There is a type of equity fund called index fund whose portfolio mirrors the stocks that comprise the index. The returns from these funds are almost same as the return of the index it is aligned to.

In a debt MF, a fund manager will invest in fixed income securities, corporate bonds, money market instruments etc.

Should you invest in MFs or ETFs?

Before we elaborate on this question, let us also consider a type of equity MF which resembles ETFs very closely – The Index funds!

Much like the ETFs, index funds also replicate a stock market index. However, the method f acquisition and selling are similar to that of MFs.

So, let us compare ETFs, MFs and Index Funds on various parameters to understand the pros and cons of each.

Difference Between Mutual Funds & Exchange Traded Funds

 

Trading Process

ETFs offer great flexibility for trading. Since these are traded on stock markets like shares, you can easily buy them at the real-time price.  You don’t have to go to the fund house for either buying or selling. Much like the shares, intra-day trading is allowed for ETFs.

MFs and Index Funds have to be bought from fund houses, and all redemptions also have to be routed to the fund house. Since the fund house has to allocate the units, intra-day trading of MF units is not possible.

Timeframe for purchase

ETFs can be bought at any time of the day at the prevailing market price.

For all types of MFs including Index funds, no matter at what time you have submitted the request, the units are allotted at the end of trading hours. The NAV applicable to the purchase is determined by the time of request submission during trading hours.

Fund Expenses

The expenses of an ETF are very low as the portfolio is aligned to an index, and the fund manager has to only replicate the index.

In Debt MFs, Hybrid MFs and Equity MFs except for Index funds, the expenses can vary depending on the type of fund. Funds which require active fund management  will have higher expenses. E.g. Large Cap funds, Multicap funds etc. Funds which require less involvement of the fund manager have lower expenses. E.g. Debt Funds

Though Index funds are passively managed, and the fund manager has to just replicate the index, the expenses are higher than ETFs because of in-built commissions and loads.

Transaction costs

For ETFs, you have to bear the brokerage costs of trading on the stock exchange and also pay STT of 0.001% on sale.

Transaction costs are nil for all type of mutual funds including index funds.

Minimum investment

There is no such thing as a minimum investment in ETFs. You have to buy minimum 1 unit of ETF at a time and at the real-time market price. You cannot set a fixed sum to buy ETFs every month.

Minimum investments in MFs vary from Rs.1000 to Ra.10000 for lumpsum purchase. In MFs, you can even set up a SIP to invest a fixed sum every month.

Market Value at the time of purchase

For ETFs, the market price keeps varying during the trading hours. The value of purchase will be the real-time market value. However, the fund houses which own the ETF provide an indicative NAV for the day called as iNAV after trading hours.

Depending on the time of submission of the purchase request, the NAV applicable for purchase of MF unit is determined. For Equity MFs and Debt MFs, the cut-off time is 3 PM. For all purchase requests received before 3 PM, the same day NAV is applicable, and NAV of the next day is applicable if requests are submitted after 3 PM.

Risk

ETFs are less risky as compared to MFs including index funds. Since there is no pressure to have cash on hand to meet the redemption requests, the fund manager can correctly replicate the benchmarked index and eliminate tracking error.

MFs come with various degrees of risk. Actively managed equity funds like Large-cap funds, hybrid funds etc. carry a high degree of risk. These funds are subjected to the risk of fund manager’s discretion which sometimes may result in lower returns than the index.

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Index MFs are passively managed funds in which the portfolio replicates that of the index it is benchmarked to. Also, a tracking error might happen while trying to follow the index.

Also read: Beginners Guide to Investing in Exchange Traded Funds(ETF’s)

ETF returns are usually same as that of the index to which they are benchmarked.

Returns of the MFs, whose funds are actively managed are usually higher than the index as the fund manager always targets to beat the index returns.

In an index fund, the returns are almost the same as that of the benchmarked index. Due to tracking error by the fund manager, the returns may be slightly lower than that of the index.

Investment Choices

The ETFs available in the market currently are either index-based ETFs or commodity-based ETFs.

A wide variety of investment categories are available for MF investors. Fund houses bring out funds based on market cap, on themes, on sectors, on indices and on different countries. Investors get a variety of choices to choose their ideal investment category.

Taxability on sale

The tax on the sale of ETFs depends on the type of ETF. For Commodity ETFs like Gold and Silver, if you sell it after 3 year holding period, a tax of 10% without indexation and 20% with indexation. If you sell within 3 years of buying the ETF, you have to pay at the income tax slab rate. However, for Index ETFs, if the holding period is more than a year, it is considered as long-term capital gain and is not taxed. However, if you sell it within a year of purchase, a tax of 15% is applied.

For Equity MFs, if the holding period is more than a year, it is considered as long-term capital gain and is not taxed. However, if you sell it within a year of purchase, a tax of 15% is applied. For Debt MFs, if you sell it after 3 year holding period, a tax of 10% without indexation and 20% with indexation. If you sell within 3 years of buying the Debt fund units, you have to pay at the income tax slab rate.

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Final Words

Though ETFs offer flexibility and liquidity, it still does not offer the returns or varied investment options as compared to MFs. Also, ETFs may not always be available for immediate purchase on stock exchanges and cannot be purchased by a fixed amount every month.

Though the expenses of MFs are higher compared to ETFs, it gets compensated by the superior performance of the MFs. Index funds which also mirrors an index are a better choice when compared from taxability perspective.

However, if you still want to buy ETFs to invest in stock market, limit your exposure to ETFs and use it only for arbitrage or hedging in your portfolio.

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