Advertising professional Vandana Rao, 28, has invested in Mutual Funds for three years. Until recently, she had been content with the performance of her portfolio, but a recent discussion on passive investing with a friend had caused her to pause. Even though she had never invested in passive Mutual Funds, Vandana was aware of them. Her acquaintance had suggested Exchange Traded Funds (ETFs), but she had no idea what they were. She believes she has to alter her investment approach, but she is unsure of where to begin due to her incomplete understanding.

Let's see if we can influence Vandana's choices.

What are Mutual Funds?

Mutual funds are investment vehicles that pool together money from multiple investors and use that money to buy a diversified portfolio of stocks, bonds, or other securities. Mutual funds are typically managed by professional fund managers who make decisions about what securities to buy and sell in order to achieve the fund's investment objective.

One of the main benefits of investing in Mutual Funds is diversification. Because a mutual fund invests in a broad range of securities, it can help spread risk and potentially reduce the impact of volatility on the overall portfolio. Mutual funds also offer professional management and the potential for higher returns compared to investing in individual securities.

There are many different types of mutual funds, including stock funds, bond funds, money market funds, and balanced funds, which invest in a mix of stocks and bonds. Mutual funds can also have different investment objectives, such as growth, income, or preservation of capital.

Mutual funds are sold by investment companies and are typically bought and sold at the end of the trading day. They may have fees and expenses associated with them, including an annual management fee and other expenses related to the fund's operations. It's important for investors to carefully review the fees and expenses associated with a mutual fund before investing.

What are Exchange Traded Funds (ETFs)?

Exchange-traded funds (ETFs) are investment vehicles that are similar to mutual funds, but are structured differently and trade on an exchange like individual stocks. Like mutual funds, ETFs pool together money from multiple investors and use that money to buy a diversified portfolio of stocks, bonds, or other securities.

One of the main differences between ETFs and mutual funds is the way they are priced and traded. ETFs are bought and sold on an exchange throughout the day, while mutual funds are priced once per day at the close of the market. This means that ETFs can be more flexible for investors who want to make frequent trades.

Another key difference between ETFs and mutual funds is the way they are managed. While mutual funds are typically actively managed by professional fund managers, ETFs are passively managed and aim to track the performance of a specific market index, such as the S&P 500. This means that ETFs generally have lower expense ratios than mutual funds because they do not require active management.

There are many different types of ETFs available, including those that invest in stocks, bonds, commodities, and other asset classes. ETFs can also have different investment objectives, such as growth, income, or diversification.

Like mutual funds, ETFs may have fees and expenses associated with them. It's important for investors to carefully review the fees and expenses associated with an ETF before investing.

Mutual funds vs. ETFs: How are mutual funds and ETFs similar?

Mutual funds and exchange-traded funds (ETFs) are both types of investment vehicles that pool money from multiple investors and use that money to purchase a diversified portfolio of stocks, bonds, or other securities. Both mutual funds and ETFs offer investors the benefits of diversification, professional management, and the potential for higher returns than investing in individual securities.

1. Both Pool Money from Multiple Investors

Both mutual funds and ETFs pool money from multiple investors and use that money to purchase a diversified portfolio of securities. This allows individual investors to achieve diversification and professional management without having to invest a large amount of money upfront or research and select individual securities on their own.

The money that investors contribute to a mutual fund or ETF is used to purchase a portfolio of securities that is managed by a professional investment firm. The securities in the portfolio are chosen based on the fund's investment objective and strategy. For example, a mutual fund or ETF might be designed to provide long-term growth, generate income, or target a specific market sector or geographic region.

By pooling money from multiple investors, mutual funds and ETFs are able to achieve economies of scale, which can help reduce costs and potentially increase returns for investors. However, it's important to note that past performance is not a guarantee of future results, and investing in mutual funds and ETFs carries risks, including the risk of loss. It's always important for investors to carefully consider their investment objectives and risk tolerance before making any investment decisions.

2. Both Offer Diversification

Diversification is an important risk management strategy that involves investing in a broad range of securities in order to spread out investment risk. Both mutual funds and ETFs offer investors the opportunity to diversify their portfolio by investing in a broad range of securities, which can help reduce risk and increase the likelihood of achieving long-term financial goals.

When you invest in a mutual fund or ETF, your money is used to purchase a portfolio of securities that is managed by a professional investment firm. The securities in the portfolio are chosen based on the fund's investment objective and strategy. By investing in a mutual fund or ETF, you can gain exposure to a diverse range of securities without having to research and select individual securities on your own.

It's important to note, however, that diversification does not guarantee a profit or protect against loss. It's always important for investors to carefully consider their investment objectives and risk tolerance before making any investment decisions.

3. Both Follow Passive Investment Strategies

Not necessarily. Both mutual funds and ETFs can follow either passive or active investment strategies.

A passive investment strategy, also known as index investing, involves tracking the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. Passive investment strategies aim to replicate the performance of the underlying index by holding a portfolio of securities that closely mirrors the index's composition. Passive investment strategies are typically characterized by low costs and a focus on long-term, buy-and-hold investing.

On the other hand, an active investment strategy involves actively selecting and trading securities in an effort to outperform a specific benchmark or market index. Active investment strategies are typically characterized by higher costs, as they require more research and analysis to select securities and make trades.

Both mutual funds and ETFs can follow either passive or active investment strategies, depending on the fund's investment objective and management style. It's important for investors to understand the investment strategy of a mutual fund or ETF before investing, as this can have a significant impact on the fund's risk profile and potential returns.

4. Both Provide Professional Management

Both mutual funds and ETFs are managed by professional investment firms, which research and select the securities in the fund's portfolio. This can be especially helpful for individual investors who lack the time or expertise to research and select individual securities.

When you invest in a mutual fund or ETF, your money is used to purchase a portfolio of securities that is managed by a professional investment team. The securities in the portfolio are chosen based on the fund's investment objective and strategy. The investment team conducts research and analysis to identify securities that they believe will perform well and help the fund achieve its investment objectives.

By investing in a mutual fund or ETF, you can benefit from the expertise and resources of professional investment managers, which can help you achieve your long-term financial goals. However, it's important to note that past performance is not a guarantee of future results, and investing in mutual funds and ETFs carries risks, including the risk of loss. It's always important for investors to carefully consider their investment objectives and risk tolerance before making any investment decisions.

5. Both Have NAVs

NAV, or net asset value, is a measure of the value of a mutual fund's or ETF's holdings. It represents the total value of the fund's assets minus its liabilities, divided by the number of shares outstanding.

The NAV of a mutual fund or ETF is calculated at the end of each trading day, based on the current market value of the securities in the fund's portfolio. The NAV is used to determine the price at which mutual fund and ETF shares can be bought or sold.

For example, if a mutual fund or ETF has an NAV of $100 and there are 100,000 shares outstanding, the price per share would be $1 ($100 NAV / 100,000 shares). Investors can buy or sell shares of the mutual fund or ETF at this price.

It's important to note that the NAV of a mutual fund or ETF can fluctuate based on the market value of the securities in the fund's portfolio. As a result, the price of mutual fund and ETF shares can also fluctuate. This means that the value of your investment in a mutual fund or ETF can go up or down, depending on the performance of the securities in the fund's portfolio.

Mutual funds vs ETFs: How are Mutual Funds and ETFs different?

Mutual funds and exchange-traded funds (ETFs) are both types of investment vehicles that allow investors to pool their money together with other investors and purchase a diversified portfolio of stocks, bonds, or other securities. However, there are some key differences between the two.

1. Buying and Selling Method

When it comes to buying and selling mutual funds and ETFs, there are a few key differences to consider:

Mutual funds: Investors typically buy or sell mutual funds through a broker or financial advisor, or directly through the fund company. When you buy a mutual fund, you'll usually pay the current net asset value (NAV) per share, plus any applicable sales charges. When you sell a mutual fund, you'll generally receive the NAV per share at the time of the sale, minus any applicable redemption fees.
ETFs: ETFs can be bought and sold through a brokerage account in the same way as individual stocks. When you buy an ETF, you'll pay the current market price, which may be different from the NAV. When you sell an ETF, you'll receive the market price at the time of the sale.

It's important to note that both mutual funds and ETFs may involve transaction fees when you buy or sell them, depending on the broker or financial institution you use. It's a good idea to compare the fees and expenses associated with different funds and ETFs before making a decision about which one to invest in. It's also a good idea to consider your investment goals, risk tolerance, and overall financial situation when deciding which type of investment vehicle is right for you.

2. Transaction Price Determination

The transaction price for mutual funds and ETFs is determined in different ways:

Mutual funds: The transaction price for mutual funds is typically based on the net asset value (NAV) per share. NAV is calculated by dividing the total value of the securities in the fund by the number of shares outstanding. Mutual funds are typically priced once a day, after the market closes, based on the value of the underlying securities in the fund.
ETFs: The transaction price for ETFs is based on the market price, which is determined by supply and demand on the stock exchange where the ETF is traded. ETFs are bought and sold throughout the day, like individual stocks, and their prices fluctuate based on market conditions.

3. Liquidity Levels

Liquidity refers to the ability to buy or sell an asset quickly and easily, without significantly affecting the asset's price. Mutual funds and ETFs can have different levels of liquidity, which can be an important factor to consider when choosing an investment.

Mutual funds: Mutual funds are generally considered to be relatively liquid investments. Investors can typically buy or sell mutual funds at the end of the trading day, at the NAV per share. However, some mutual funds may have redemption fees or other restrictions on selling, which can affect liquidity.
ETFs: ETFs are traded on stock exchanges like individual stocks, and their prices fluctuate throughout the day based on supply and demand. As a result, ETFs are generally considered to be more liquid than mutual funds. Investors can buy and sell ETFs at any time during the trading day, at the current market price.

It's important to note that the liquidity of a mutual fund or ETF can also depend on the underlying securities it holds. For example, a fund that holds highly liquid securities, such as large, well-known companies with high trading volumes, may be more liquid than a fund that holds less liquid securities, such as small or less well-known companies. It's a good idea to consider the liquidity of a fund or ETF when making an investment decision, and to keep in mind that all investments involve some level of risk, including the risk of loss of principal.

4. Number of Investment Strategies Offered

Both mutual funds and ETFs offer a wide range of investment strategies and options for investors. Here are a few examples:

1. Mutual funds: Mutual funds can offer a variety of investment strategies, including:

Equity funds, which invest in stocks or other equities
Bond funds, which invest in fixed income securities such as bonds
Balanced funds, which invest in a combination of equities and fixed income securities
Money market funds, which invest in short-term debt securities with high credit quality
Specialty funds, which invest in specific sectors or industries, such as technology, healthcare, or real estate

2. ETFs: ETFs can also offer a variety of investment strategies, including:

Equity ETFs, which invest in stocks or other equities
Bond ETFs, which invest in fixed income securities such as bonds
Balanced ETFs, which invest in a combination of equities and fixed income securities
Commodity ETFs, which invest in physical commodities such as gold or oil
Inverse ETFs, which aim to generate returns that are opposite to the performance of a specific market index or benchmark

It's important to note that both mutual funds and ETFs may have different levels of risk and potential for return, depending on the investment strategy they employ. It's a good idea to carefully consider your investment goals, risk tolerance, and overall financial situation when choosing an investment strategy, and to consult with a financial advisor or professional if you have any questions or concerns.

5. Expense Ratio

The expense ratio is a measure of the costs associated with managing and operating a mutual fund or ETF. It is expressed as a percentage of the fund's assets, and it includes expenses such as management fees, marketing and distribution costs, and other administrative expenses.

The expense ratio is deducted from a fund's returns, and it can have a significant impact on the fund's overall performance. For example, a fund with a high expense ratio may have lower returns than a similar fund with a lower expense ratio, all other things being equal.

It's important to note that mutual funds and ETFs can have different expense ratios, and it's a good idea to compare the expense ratios of different funds and ETFs before making a decision about which one to invest in. It's also a good idea to consider the impact of the expense ratio on your potential returns, as well as other factors such as the fund's investment strategy and risk level.

It's worth noting that some mutual funds and ETFs may have additional fees or charges beyond the expense ratio, such as redemption fees or sales charges, which can also affect the overall costs of the investment. It's a good idea to carefully review the fees and charges associated with any fund or ETF before making an investment decision.

6. Level of Flexibility

You can use mutual funds to make investments through a systematic investment strategy (SIP). This means that you can consistently invest a certain amount in a certain programme. According to your directions, the same will be automatically taken out of your bank account.

However, there is no SIP function available for ETFs. A SIP would need to be manually set up for an exchange-traded fund, just like it would for stocks. Most likely, you would set an investing interval and manually monitor it to ensure that you invest during that time. As with a mutual fund SIP, there is no auto-debit.

Bottom Line

The main concern for Vandana right now is whether she should invest in a mutual fund or an ETF. She's been intrigued by the notion of "purchasing the market" and wants to try it out. That would depend on her risk tolerance and whether it suited her financial philosophies, I suppose.

She would be better off investing in an index fund and adding money on occasion if she wants a passive fund that tracks an index but doesn't want the inconvenience of creating a broker account. On the other hand, she can choose ETFs if she wants to take a more active part in managing her money and wants to profit from market volatility. A third choice is to make little investments in both and then decide where to go from there based on the returns and comfort. At the end of the day, in addition to returns, you should consider your risk tolerance, how simple it is to invest, and your understanding of the product.

So, let’s leave Vandana with this thought and wish her success in her investment journey.

Mutual Funds vs ETF: A Comparison