How ETFs are different from Mutual Funds: A Beginner’s Guide

Let us consider the basic differences between Exchange Traded Funds (ETFs) and mutual funds and when should one use either product.  A couple of announcements first: (A) I will be speaking on “index investing and market timing” this Sunday, 17th June in the Tamilnadu Investors’ Association monthly meeting (see invite below). Do join if possible. (B) If you are using my Features of the freefincal mutual fund and financial goal tracker, then due to the fund mergers you need to make some changes to the sheet to make it work right. You can download the list of changes here. I will release an update shortly.

Differences between ETFs and Mutual Funds

Please note that this is written by a novice with the beginner in mind.

What is a mutual fund? A mutual fund is a pool of investor money used to purchase stocks/bonds by the fund house. That is, the fund house takes investor money and invests in securities (stocks or bonds) on their behalf. So you are essentially asking a fund manager to buy and sell stocks or bonds for you. Just that she will make the same investments for all investors. The invested assets of a fund are divided into units and these are sold for money. The  fund house directly deals with investors and sales guys (distributors)

What is an ETF? Short answer: A ETF allows you to buy and sell an entire index like a stock. Hence the name exchange-traded fund. Long answer: The fund house creates a basket of securities with the help of institutional investors or large investors in what is known as the primary market. These ETF units can then be traded among investors with the help of a broker (demat account) in the secondary market. The fund house does not directly deal with investors and distributors. So ETFs do not have commissions and hence are not “pushed”

What do I need to start investing in mutual funds? You need a bank account, valid ID proof and address proof. With these, you can apply for ID verification (know your customer or KYC) and then apply for purchase of units directly with the fund house. Some basic understanding of risk will help.

What do I need to start investing in ETFs? The same as above, but you need to get apply for a demat account from a broker.

How do mutual funds invest? Either they track the stocks or bonds in an index or invest as per their own strategy. A mutual fund that tracks an index is known as an index fund and a mutual fund that invests by its own rules is known as an active fund.

How do ETFs invest? An ETF always follows a particular index. So each unit is 1/10th or 1/100th (for eg.) of an index.  This index can simply be a passive index where stocks are selected based on their market cap or an active index where stocks are selected via a particular investment strategy. See for example: How new stock investors can quickly start investing using NIFTY Multi-Factor Indices

Differences between mutual funds and ETFs a beginners guide
Adapted from wiki image

How can I buy or sell mutual funds?  You buy units from the fund (when you invest) or you sell units (when you wish to exit) at a price decided at the end of the trading day.  You cannot trade mutual fund units during a business day.

How can I buy or sell ETFs? You can buy and sell units during the trading day. It is not possible to buy or sell at the closing price! If there is a big difference between the price of the unit and its NAV, you can lose or gain when you buy/sell. So investors must exercise caution.

At what price can I buy/sell mutual funds? The price will always be equal to the NAV when you buy as there is no entry load. When you sell the price may be less than the NAV if there is an exit load. NAV stands for the value of each mutual fund or ETF unit after deducting expenses.

At what price can I buy/sell ETFs? The price may be higher or lower than the NAV as they are governed by supply and demand among the ETF investors (in the secondary market), the exchange rate in the case of international ETFs.

How about the supply of units? In an open-ended mutual fund, there is an unlimited supply of units and you transact directly with the fund house. A closed-ended fund is one with a limited supply of units. So you can only buy them during the offer period. Later you can trade them like ETF units in the secondary market with a demat account. The price of such closed-ended funds will usually be higher than the NAV

The supply of ETF units is flexible. If there is more demand, the fund house will contact the authorised participants and create more units. Large investors can buy ETF units in bulk directly from the fund house.

Which is more expensive? Mutual funds have higher expenses that are linked to the total money (asset) in the fund. Lower the assets, higher the expenses.

In the case of ETFs, since the fund house do not directly interact with investors, the asset linked expenses are lower. Recently many ETFs have slashed expenses to attract institional money (EPF) There will be additional brokerage expenses when investors buy/sell but this is linked with the individual investment amount.

 Which is better? If you are a new investor, stick to mutual funds. If you wish to beat a given benchmark on risk-adjusted basis based on a flexible investment approach, then you can only choose active mutual funds. If you wish to be a passive investor, and will only book profit or rebalance once a year or so, then (index) mutual funds will work for you.

If you wish to actively trade in ETF units or if you wish to tactically change asset allocation frequently say once a month then ETFs will work for you as they do not have exit load. However, the ETFs you choose should not have too much price vs NAV difference else selling or buying can be frustrating and take time. Only a few ETFs have such a low difference in India. More on that in the next post.

How are dividends handled in mutual funds? Dividends from stocks are always reinvested in a mutual fund. The mutual fund can book profit and distribute them (these are also unfortunately known as dividends ) if the investor has chosen the dividend option. This is different from a stock dividend!

How are dividends handled in ETFs? Dividends from stocks are held as cash and are either passed on to unitholders or can be reinvested into the ETF. This cash component can result in a difference in return between the ETF and the underlying index. This is known as tracking error (expenses also contributes). In addition, ETFs also have the option to book profit and pass on the gains as dividends like mutual funds do.

Is there any difference in taxation? No. Any fund or ETF that hold more than 65% of Indian stocks on average (monthly in an FY) is classified as an equity fund by the taxman. All other funds or ETFs are non-equity funds. A mutual fund that invests in equity ETFs is also an equity fund (this is only from April 1st, 2018).

Summary The difference between a good product and bad product always commissions. Increase the commission in a so-called bad product and it will be immediately pushed as good. ETFs have not been pushed as good because they do not have any commissions associated. As a result, only a few ETFs are popular and are heavily traded. None of these is a  particularly good investment choice with the exception of NIfty and Sensex ETFs (if you don’t care about outperformance).

The rest of the ETF (including many interesting ones) are thinly traded resulting in a huge difference in price and NAV. This can be frustrating to buy and sell. If we need money quickly we may have to take a significant loss if the price is lower than the NAV. Thus in spite of their low expenses, ETFs are not so endearing in my opinion. Here is a  List of Index Mutual Funds and ETFs in India: What to choose and what to avoid

Also see: Index Investing: advantages and disadvantages of being a passive investor 

In the next part, we shall analyse the liquidity (ease of buying and selling) of ETFs. If I have left out any difference, please comment below.

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