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ETF vs. Mutual Fund: What is the Difference and Which One to Choose

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ETF vs. Mutual Fund: What is the Difference and Which One to Choose

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Choosing the right investment option for you can be difficult. There are so many options in the market to select from. All of them carry varying degrees of risk and reward and having a mix of these investment options is required for an optimal portfolio. In this list of options, mutual funds and exchange-traded funds (ETFs) stand out as among the most popular choices for investors.

Firstly, what are mutual funds and ETFs?

A mutual fund is a fund managed by a professional that trades in diversified holdings. The funds are pooled in by various investors and are handled by professional fund managers who trade on your behalf. The investment portfolio can include bonds, shares and money market instruments. Mutual funds are bought at a net asset value which is closest to their price when the market closes for the day. 

ETFs (Exchange Traded Funds), on the other hand, are funds that trade on exchanges like stocks. They contain a combination of various assets like stocks, commodities and bonds. These can be bought and sold at exchanges just like stocks. ETFs passively track indices by matching their price movements closely. 

ETF vs Mutual Funds

Here’s a list of the differences between mutual funds and exchange-traded funds:

Risk & returns - ETFs vs Mutual Funds

There is always some amount of risk associated with both mutual funds and ETFs but the returns are in the same proportion. Though both ETF and mutual funds generally are less risky investment instruments compared to stocks, the risk is not completely mitigated.

Mutual funds

Here are the risks and rewards associated with mutual funds:

Risks

Market risk

Market risks emerge due to volatility. The market is influenced by numerous factors like disasters, inflation, recession, political upheaval and interest rate fluctuations. These are systematic risks that cannot be controlled by the investor in any way.

Interest rate risk:

 Interest rates fluctuate based on the amount of credit available from lenders and how it matches borrowers' demands. An increase in interest rates at the time of investment may cause the price of securities to fall.

Concentration risk:

 Putting a significant portion of money in one plan is never a good idea. Portfolio diversification is the best way to reduce this risk. 

Returns

Mutual funds attract several types of returns. Here are some of them:

Annualised returns: 

The amount of growth in the value of your investment on an annual basis is measured by annualised returns.

Total returns

This is the amount of money one makes from their investment. Dividends and capital gains are both included in this amount.

Trailing returns:

These are the annualised returns over a specific trailing period that ends today.

Rolling returns

Rolling returns are the annualised returns over a specific time period. This could be monthly, weekly, or daily. These must be used in comparison to the scheme or fund category's benchmark until the last day of the duration.

Point to point return:

It is the annualised return calculated between two dates.You can calculate these returns from the mutual fund schemes' start and end dates.

ETFs

Risks

These are the rewards and risks associated with ETFs:

Market risk

The underlying asset in an ETF consists of stocks, so the fluctuations of the stock market have an impact on the price of the ETF unit held by an investor.

Complexity:

 ETFs incorporate a range of investment instruments, giving investors more exposure. However, the more complex the fund, the harder it is to track the performance of these diverse investments.

Tax risks

The tax implications of ETFs can be hard to understand because they all have different structures. For example, an ETF that consists of commodities and derivatives may also have complex tax implications.

Returns

Returns earned from ETFs can be in the form of capital appreciation, meaning, just like stocks, you purchase them at a particular price and sell them at a higher price on the exchange. Some ETFs also have a dividend component attached to them, so you can also earn through dividends from the underlying stocks that an ETF comprises.

Which is better for what age/life goal?

ETFs

Exchange-traded funds are a great investment tool preferably for young investors. Here’s why –

Diverse portfolio:

 ETFs give exposure to a diversified portfolio like equity, bonds and more, balancing risks and returns in a healthy manner.

Small investment amount

Young investors tend to have lower access to funds which makes ETFs attractive since they do not require large amounts of funds.

Variety

ETFs are available in several asset classes like stocks, currencies and commodities and across various sectors.

Liquidity

Investors can easily sell off their ETFs and gain access to funds when they are needed.

Mutual funds

Mutual funds are a great investment tool for investors across all age categories. Here’s why

Various asset classes:

Much like ETFs, mutual funds also invest in various asset classes, giving investors exposure to multiple markets.

Manageable SIPs

Investors of all capacities can invest in mutual funds by paying affordable monthly SIPs (Systematic Investment Plans).

Liquidity:

Mutual funds differ from ETFs since they cannot be sold off and converted into cash as easily as ETFs. This makes it ideal for investors looking for medium-term investment.

In a nutshell

Although in theory mutual funds and ETFs are similar in terms of asset allocation, they do differ when it comes to costs and liquidating funds. Based on your investment goals, income and age, you should carry out your own research and arrive at the best allocation of funds. A healthy balance of these investments along with other investment tools is essential for a well-rounded portfolio.

FAQs on how choosing either can impact wealth generation

1) Can I get high returns on mutual funds?

Mutual funds carry some degree of risk. You can invest in debt mutual funds for short term returns. But to build wealth in the long term, equity mutual funds are the best bet.

2) Can you retire with ETFs alone?

It's a good idea to invest in a range of options to build a retirement fund. Investors need to determine the allocation of funds by taking into account market risk and getting a good balance of risk and return. Investors should actively monitor their investments.

3) How many ETFs should you have in your portfolio?

A spread of five to ten ETFs across various asset classes, sectors, nationalities and geographies are optimal for a well-balanced ETF portfolio.

4) What percentage of a portfolio should be ETFs?

It is advised that ETFs should make up for not more than 30% of your bond investments and 40% of your stock investments.

5) What is a good mutual fund allocation?

By some estimates, an investor should allocate 40% of their investment in large-cap stock funds, 10% in small-cap funds and 30% to an intermediate bond fund. Around 15% of it should be given to foreign stock funds. But the allocation may differ based on individual goals and risks involved.

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