Know how an Exchange Traded Fund (ETF) is different from a mutual fund?

Only if you make the right investment decision, you will be successful in achieving your life’s financial goals. Investors generally end up investing in a scheme only based on its past performance. This must not be the approach as you are taking an important decision in your life, an investment decision that might help you become wealthy in the long run. One of the best ways to create wealth over the long term can be through mutual funds. Mutual funds pool funds to form a portfolio of diversified securities and give investors an opportunity to earn capital appreciation over the long term. While most mutual funds like equity funds and debt funds usually form an investor’s portfolio investors can even consider investing in passive funds like ETFs.

Let us find out what ETFs are and what makes them different from other mutual funds?

What is an ETF?

Also referred to as exchange traded funds, both ETFs and mutual funds pool funds from investors to invest in a basket of diversified securities. While this investment strategy remains the same, there are a few things that distinguish ETFs from other types of active mutual funds. An ETF is an open ended mutual fund scheme that aims at generating capital appreciation by mimicking the performance of its underlying benchmark. ETFs, invest in securities in the same way as they as present in the underlying index in the same proportion without changing the portfolio composition.

Difference between ETF and mutual funds

To begin with, an ETF is a passively managed fund while other mutual funds are actively managed. Passive management means the fund manager does not actively trade with the underlying securities of an ETF but instead structures the portfolio in such a way that the exchange traded fund is able to mimic the performance of these securities to generate returns with minimum tracking error. While active funds try to outperform their underlying benchmark, ETFs do not try to outperform but only replicate their benchmark’s performance.

Another difference is that mutual funds that are actively managed have a relatively high expense ratio than passive funds. An expense ratio is nothing but recurring costs like management and operational costs which the fund house has to bear to ensure the smooth functioning of the funds. They recover these costs through the expense ratio which is deducted from the investor’s capital gains. Over the long run, investing in a scheme with a high expense ratio can seriously impact one’s long term returns. Thus, investors can consider ETFs as these are passively managed and hence have a low expense ratio.

One major difference between ETF and mutual funds is that ETFs are listed on almost every stock exchange and investors can buy or sell their ETF units just like company stocks during live trading hours. Since these are listed at the exchange, investors can enter and exit their ETF investment end several times to make a profit. This is not the case with other mutual funds where the investor has to place a request with the AMC for the purchase or sale of their units. Also, they can only buy or sell units based on the NAV of the scheme which is determined at the end of the day.

Another difference is that investors need to open a demat account in order to trade with ETF units. One needs a demat account to store their bought ETF units. To invest in regular mutual funds, investors do not need a demat account and invest with their regular mutual fund investment account.