Difference Between ETF and Mutual Fund

ETF vs. Mutual Funds: An Overview

These days young people are more inclined towards investing their money so that they will get excellent returns within no time. Regards to this, the most difficult decision that an investor has to take is choosing the one out of mutual fund vs ETF. These investment options pool investor deposits and purchase several individual stocks, bonds, and other assets.

ETFs are freely traded on the stock market, allowing investors to buy or sell shares per their needs. If you talk about the market price of these shares, then it may be seen in real-time, just like regular shares. In the case of mutual funds, you have to submit a request to the fund houses to acquire or sell mutual funds. 

Furthermore, no commission fee is associated while selling or purchasing mutual funds. However, ETFs are exchanged but have to pay some fee while trading. On the other hand, an ETF has a minimum lock-in period, so you are free to swap your shares whenever you want without any incusing fee. 

Additionally, mutual funds have holding periods that start from 90 days to 3 years, and you have to pay a severe fine if you purchase or sell shares within this period. To know what the difference is between mutual funds and ETFs, read the below remaining post.
 

Mutual Funds

A mutual fund is a type of financial instrument that combines money from investors to buy stocks, bonds, and other assets. Companies that are eligible to establish mutual funds establish Asset Management Companies (AMCs) or Fund Houses, which collect investor cash, promote mutual funds, handle investments, and facilitate investor transactions. Mutual funds might appear scary or confusing. We'll make an effort to make things as simple as possible for you. A mutual fund is essentially made up of the money that many different persons (or investors) have pooled together.
 
Mutual funds typically require a higher minimum investment than ETFs. Further, these minimum requirements can vary depending on the type of company and fund scheme. Most mutual funds are managed actively by an experienced fund manager or team that makes buying and selling decisions on the behalf of investors in order to provide them with higher returns. Such types of funds incur a higher cost as they require more effort, processing time, and expertise altogether. 
 
Moreover, the buying and selling of mutual funds happen directly between the fund and the investors. Also, the price of mutual funds is not determined until the NAV (Net Asset Value) is determined at the end of the business day. 
 

Types of mutual funds

Mutual funds are categorized into four types. They are: -

●    Equity mutual funds
●    Bond mutual funds
●    Short-term debt mutual funds
●    Hybrid mutual funds

Each of them carries its risks along with capturing wider market gains, but some of them are riskier than others, along with offering higher potential rewards. 
 

Exchange-Traded Funds (ETFs)

In a nutshell, an ETF is a collection of assets that you may purchase or sell on a stock market through a brokerage company. Almost any asset class imaginable, including traditional investments and so-called alternative assets like commodities or currencies, is available as an ETF. Innovative ETF designs also give investors access to leverage, market shorting, and tax-free short-term capital gains.
ETFs typically require a small minimum amount as an initial investment. Investors have to pay as less as the price of one share and the fees of the fund house. Further, these are created in comparatively larger lots by institutional investors. Also, the shares trade all day just like stocks. 
Similar to a stock, an ETF can also be sold short. However, this facility is great for spectaculars and traders but has no meaning for the long term investors. Because ETFs are continuously priced by the market, there is always a chance for trading to take place at a higher price than the actual NAV. 
 
Furthermore, ETFs offer many tax benefits to investors. But because they are passively managed funds, they realize less capital gains as compared to mutual funds. 

What is the difference between an ETF and a Mutual Fund?

Now that you've read about the detailed overview of mutual funds and ETFs, let's look at their key differences :
 

ETF Creation and Redemption

The creation of an ETF and redemption is a unique process of an ETF that sets this investment apart from all other investment vehicles. This benefit allows the investor to trade on stock exchanges while keeping very close correlation in regards to assets they will track.

Basically, creation is the purchasing of all the securities and then finishing them into an exchange-traded funds structure. On the other hand, in the case of redemption, the ETF is unwrapped back into single securities. 

This whole structure of creation and redemption of the ETF took place in the primary market between the ETF sponsor and authorized participants. In the beginning, you will find the creation and redemption process a bit tricky, but with the passing of time, you will get to know all about them, and it is an essential part to get the potential benefits. 

Some of the benefits of the creation and redemption process of mutual funds vs ETFs are: -

●    Due to the creation and redemption process, the APs, called authorized participants, closely monitor the demands for exchange traded funds and then move further in purchasing or selling of shares.
●    Both creation and redemption processes are conducted in the form of goods or services because of which they are free from tax, which improves the overall tax state.
●    Creation and redemption create double layers of assets inside an ETF.
 

ETF Benefits

Following are the key benefits of ETFs:

● Investors can buy ETFs on margin and also sell them short when needed. 
● Investors can buy as little as one share as there is no minimum investment requirement. 
● They can be purchased and sold at a price that varies throughout the business day. But the transactions can take place in real-time as well. 
● Cost is by far ETFs' largest benefit versus actively managed funds. ETF fee ratios can range from 1.5 to 2.25% below the actively managed fund expense ratios.
● ETFs operate similarly to other index funds in that unit subscription and redemption involve the exchange of underlying securities rather than cash 

Structures of ETFs

There are several inherent benefits of ETFs, and several of them wholly depend upon the type of legal structure involved. Experts financial advisors first understand these legal structures to determine how ETF investments will benefit clients' portfolios. There are a total of seven ETF structures. 

1.    Open-end funds

A maximum number of ETFs are under the open-end funds that fall under the regulatory measures of the Investment Company Act of 1940. This type of structure offers investors exposure to the most common assets like stocks and bonds. 

2.    Unit investment trusts (UTIs)

It is an investment company that delivers fixed portfolios like stocks and bonds for a specific period of time.

3.    Exchange-traded notes (ETNs)

They are also known as ETNs and are prepaid forward contracts that promise to pay a sum equal to the return realized from an index.

4.    Grantor trusts

ETFs are also structured as grantor trusts that basically invest in commodities or currencies.

5.    C Corporations

This kind of ETF structure is used to access particular types of partnerships along with special-purpose vehicles called SPVs.

6.    Exchange-traded managed funds

It melds the active component of mutual funds with the intraday flexibility of an ETF. Apart from that, ETMFs disclose their holdings every quarter rather than daily, like mutual funds.

7.    Partnerships

ETFs are also structured as a partnership shown as incorporated business entities so that they are subject to the double taxation of the company.
 

Mutual Fund Vs ETF — Which Option to Choose?

Both investment options we have discussed above allow you to build an excellent investment portfolio and generate better returns. However, both have their own perks and drawbacks which should be kept in mind while picking anyone. The right selection depends entirely on your financial goals, experience levels, risk appetite and a few other factors. Before selecting the right option, ask yourself the following questions:

● What is your risk appetite? 

● What are your liquidity concerns? 

● What are your financial goals? 

● What is your investment horizon?

● Do you have any tax-saving strategies? 
 
After answering these questions, you will be able to decide what is the right option for you. Mutual funds may require you to stay invested for a longer period of time, but help you generate higher returns for the future. But if you need the flexibility of managing your funds and want to stay invested for a short-term, then an ETF can be a great option for you. The decision is completely yours, but you have to make it carefully for your own good. We hope this article will help you in selecting the right investment option. Also, if you want to become a smart investor and invest in a risk-free way, then visit 5Paisa! 

Conclusion

Both mutual funds vs ETFs deliver significant investment opportunities to young investors. That means they help in building an excellent investment portfolio by generating better results. On the other hand, both have their advantages and disadvantages which you must keep in mind while choosing the one. Whatever you select depends upon an individual investor's financial goals, acceptable costs, investing style, etc.

 So, decide with due care and select the right investment option by studying the ETF and mutual fund differences. For more details and guidance, you can contact 5Paisa.