Investing funds is a proven way to growing your capital to meet your future fund requirements. Investing can help protect your capital from inflation and also grow it because of the compounding effect. Whether the investment provides inflation beating returns depends on where the funds are invested.
One of the most popular investment options for people is investing in the stock market. Stock market investments can either be investing in shares, mutual funds, other funds, commodities, currencies or derivatives. These investments differ in their risk, returns and complexity.
Out of these different stock market related investments, investment in mutual funds is generally preferred by most investors. Mutual funds pool resources from many different investors and invest those funds in different assets. This helps with portfolio diversification and also provides a good way for capital growth.
There are different types of mutual funds available in the market based on which assets the resources are invested in:
- Equity mutual funds
- Debt mutual funds
- Hybrid mutual funds
- Tax saving funds or Equity Linked Savings Schemes (ELSS)
- Exchange Traded Funds and Arbitrage funds
With the benchmark indices showing a consistent double digit growth, a fair number of investors have started seeing the value in exchange traded funds or ETFs. ETF’s are similar to mutual funds, however, they have some marked differences which distinguish them from mutual funds.
Let us examine the differences between mutual funds and ETFs:
1. Active vs Passive:
This is the biggest distinguishing point between mutual funds and ETFs. Mutual funds are actively managed i.e a professional manager decides an investment strategy for the resources collected. This investment strategy constantly changes depending on the performance of the assets and the market conditions. This investment strategy depends on market research reports, company financials and general economic and market trends. On the other hand, ETFs are passive funds. They mimic the growth of the asset they invest in. For example, an index fund invests its resources in equity shares that comprise that particular index; a Nifty 50 Index Fund will replicate the holding pattern of stocks that comprise the Nifty 50. As such, this fund will give returns similar to the return of the benchmark index. This strategy remains the same throughout the fund duration. The only change happens when the benchmark index changes the composition of equities.
2. Expense ratio:
Actively managed mutual funds have a higher expense ratio as compared to passive funds. Passive funds don’t need to look into their strategy and evaluate the results constantly. As a result, they also don’t need to invest in research reports. This reduces the expense burden considerably. On the other hand, actively managed funds need to spend time and money in making sure their investment strategy is providing returns to the investors.
3. Purchase and Redemption:
Actively managed funds have to be purchased from the mutual fund house. Even though the mutual fund house publishes the NAV every day, all purchases and redemptions happen through the mutual fund house. On the other hand, ETFs and Index Funds are listed on the stock exchange and can be purchased just like equity shares.
Commissions for investments in mutual funds are paid to brokers who route their client’s mutual funds investments into the particular mutual fund. On the other hand, ETFs are like stocks which means the investor needs to pay brokerage to the broker for investments.
5. Lock in periods:
ETFs have no lock in period associated with them unlike close ended mutual funds and tax saving ELSS which has a lock in period of 3 years.
Index Funds and ETFs provide a way to passive invest in a growing asset. With consistent growth in the benchmark indices, investing some portion of funds in a passive ETF is also a strategy that conservative investors can adopt for higher returns.