Personal Finance: Mutual Funds Versus Exchange-Traded Funds

Mutual funds vs ETFs

Mutual funds and ETFs are some of the most efficient investment instruments; however, they are often confused with each other. Understanding your finances better will get you more opportunities to invest them in the appropriate avenues. 

The cruciality of managing personal finance cannot be overemphasized. It not only becomes important to plan and budget prudently but also to invest wisely.

There are a lot of investment instruments available in the market and you have the liberty to choose among them. What’s better is that you can even choose a plethora of securities and pool your money with other investors to reap the benefits proportionately. 

And here, mutual funds and exchange-traded funds come into play. 

In order to understand the meaning of and the differences between mutual funds and exchange-traded funds, let’s say you are house hunting. Although there are several apartments available in the locale, you wish to lease a house with a modular kitchen, a pool view, a modern interior, and a big, spacious balcony. 

However, you may not able to get everything together in one house. But you can contact a realtor who can help you find a great listing. You could then pitch in with others and share the rent with them. You can then only pay for a part of the house and get to enjoy your stay.

In this scenario, if the house is a mutual fund, then you are an investor, the realtor is the fund manager, and your co-owners are the other holders of the fund. 

On the other hand, in an exchange-traded fund, there will also be a broker involved in the scenario who will help facilitate the transaction.

There is a fine line between mutual funds and ETFs even though both tools offer investment packages that a person can use to create a diversified investment portfolio.

The following points will better explain the differences between both the funds:

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Flexibility

• ETF transactions can take place at the convenience of the fund holder. They are traded freely in the market on a daily basis, hence offering more flexibility. Mutual funds, on the other hand, can only be bought and sold only by placing a request with the fund house. With respect to the shifts in the market value, ETFs can be bought and sold in the stock market throughout the day during the designated hours.

Fees

• ETFs do not require large fees because they are passively managed. They are cheaper than mutual funds because ETFs essentially track the performance of an index. Mutual funds call for active management which leads to a relatively higher fee structure.

Tax benefits

• ETFs incur lesser capital gains than mutual funds and, as a result, they are not payable frequently. Since mutual funds are actively managed, the increased managerial activities lead to higher capital gains, thus making ETFs more tax efficient.

Holding period

• The holding period required in the case of ETFs has no bar. There is no minimum holding period as they can be traded on a daily basis. This increases the liquidity in the hands of the investors and gives them quite some flexibility to hold the ETF as per their needs. Mutual funds, however, do have a minimum holding period. So, if you’re thinking long-term, then this option might be more suitable.

Transferability and procedural ease

• The ease of transferability is found more in ETFs as they are quite portable. However, with regards to mutual funds, there are certain complexities that may arise during the transfer.
• More so, the procedure of investing in ETFs is simpler because there are no fund houses or fund managers involved in the transaction, and ETFs, as opposed to mutual funds, offer more flexibility.
• All in all, both funds offer baskets of securities that you may opt for according to your preferences, your risk-taking capacity, your strategy, and your return expectations.

Conclusion 

If you wish to have liquidity, then certainly ETFs are recommended, and if you wish to receive long-term gains, then mutual funds might be the thing for you. Although this is not investment advice, you must ensure to do your research well and choose the option that would suit your needs best.

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Frequently asked questions

1. Which is better, ETF or mutual funds?

• Both the investing instruments offer unique opportunities. While ETFs are more tax-efficient, mutual funds are better for the long run. It, therefore, depends on the investor’s personal preferences. 

2. Why choose an ETF over a mutual fund?

• Choosing an ETF over a mutual fund may be opted because of the flexibility, liquidity, tax advantages, and lower expenses that are attributed to ETFs. Not to mention, there are drawbacks to ETFs as well, like any other trading instrument.

3. Do mutual funds outperform ETFs?

• Every investment avenue has its pros and cons. Some of the advantages of investing in mutual funds are the diversity and consequent risk reduction, the ability to own a share in a large portfolio, and it is overall considered to be better for the long haul. 

4. How long should you hold ETFs for?

• ETFs can be held for both long- and short-term. If you hold it for the long term, then you would be receiving long-term capital gains and if you would be holding the same for the short-term, then you would receive short-term capital gain. 

5. What is the minimum holding period for mutual funds?

• Mutual funds have a minimum holding period of one day. Their maximum holding period can extend indefinitely. That being said, mutual funds are usually opted for in the long run for better results.