When it comes to choosing market linked schemes as an investment option for the diversification of the overall investment portfolio, investors are often confused about whether they should invest in mutual funds or exchange traded funds. Although exchange traded funds are categorized as mutual funds by market regulator SEBI (Securities and Exchange Board of India), there are a few traits that distinguish them from other mutual fund schemes. So, if you too are wondering whether you should invest your hard earned money in exchange traded funds or mutual funds, this article might help you make an informed investment decision.

What is a mutual fund?

A mutual fund is a pool of professionally managed funds where the Asset Management Company accumulates financial resources from investors sharing a common investment objective and invests the sum across various asset classes, currencies, and money market instruments. Mutual funds offer active risk management through a team of professional fund managers who are involved in constantly buying and selling securities and reshuffling the portfolio to allow the fund to generate returns.

What is an exchange traded fund?

An exchange traded fund is a mutual fund scheme that is listed at almost every stock exchange just the stock of a publicly listed company. An exchange traded fund or ETF as it is commonly referred to as is an open ended scheme that tries to generate returns by replicating the performance of its underlying index or benchmark. ETFs follow a passive investment strategy and investors can buy or sell their exchange traded fund units at their real time price throughout the day during live trading hours.

Understanding the difference between exchange traded funds and mutual funds

Here are a few things that distinguish one investment product from the other:

  • As mentioned earlier exchange traded funds follow a passive investment strategy. Here, the fund manager doesn’t actively buy or sell securities for the scheme to generate returns. Instead, ETFs are designed in such a way that they mimic the performance of their underlying benchmark. This is different than mutual funds that are actively managed by the fund manager.
  • Mutual fund investors can only buy or sell units depending on it’s the NAV that is determined at the end of the day. This is not the case with exchange traded funds whose NAV can differ from the actual price movement that it witnesses during trading hours. Investors can enter or exit mutual funds at their varying market price just like investors buy company stocks as ETFs are listed at the exchange whereas other mutual funds are not.
  • Since ETFs are passively managed that has a low expense ratio. On the other hand, actively managed mutual funds have a comparatively high expense ratio.
  • The investment objective of a mutual fund is to outperform its underlying benchmark by investing in a diversified portfolio of securities. The investment objective of an ETF is to replicate the performance of its underlying index with minimal tracking error. They do not try to outperform their benchmark but try to replicate similar returns.

Whether you choose ETF or mutual funds, the best way to remain invested for the long haul is through SIP. Systematic Investment Plan is a simple and convenient way to save and invest a fixed sum regularly. Investors can even make use of an online SIP calculator, a free tool that computes results from the data provided in just a few seconds. Neither mutual funds nor ETFs guarantee returns which is why investors should not depend on anyone asset class for income generation and must ensure that they have a well-diversified portfolio.