ETFs vs Mutual Funds - Which is Better for Long Term?

As an investor who is navigating the evolving landscape of Indian financial markets, understanding the key differences between exchange-traded funds (ETFs) and Mutual Funds is a very crucial thing. Both investment vehicles offer a diverse portfolio, while they have various significant differences in structure, costs, taxation, and how they are traded. Let’s understand the essential factors to consider when choosing between ETFs and Mutual Funds.

What Are ETFs and Mutual Funds?

Exchange-Traded Funds (ETFs): ETFs are passive investment funds that are traded in the exchange NSE & BSE like individual stocks. ETFs replicate the performance of their underlying indices within sectors, by providing diversified exposure to a wide range of assets. They can be bought and sold throughout the trading day during market hours, and their prices fluctuate based on market fluctuations.

Mutual Funds: Mutual Funds pool money from different investors to create a diversified portfolio of stocks, bonds, with other financial products. These funds can be actively or passively managed by fund managers of AMCs and are bought or sold only once a day, after the market closes, at the fund’s Net Asset Value (NAV).

How ETFs and Mutual Funds are Traded?

ETFs: ETFs can be bought and sold on stock exchanges during market hours, and their prices will change throughout the day. This means an investor might purchase an ETF at a different price than another investor, based on market fluctuations during the trading session.

Mutual Funds: Mutual Funds do not trade on an exchange like ETFs. They are bought directly from the fund house or distributors, and their price of NAV is determined at the end of the day based on the Market Movement. This fixed pricing means that everyone investing in the same mutual fund on the same day will pay the same price.

How ETFs and Mutual Funds are Managed?

ETFs: ETFs are typically passively managed financial instruments, while they track a specific index without trying to outperform it.

Example: An ETF replicating the Nifty 50 will hold the same stocks as in the Nifty 50 index in a different proportion. Since they don’t require active decision-making from fund managers, the management fees for ETFs are usually lower compared to Mutual Funds.

Mutual Funds: Mutual Funds are often Actively as well as Passively managed. Fund managers make investment decisions along with the research team by aiming to outperform a specific benchmark. Active management can potentially lead to higher returns, but it often comes with higher fees due to research and trading costs.

Which costs more ETF or Mutual Funds, and Why?

ETFs: Generally, ETFs have lower expense ratios as compared to Mutual Funds due to their passive management approach. However, investors should be aware of broking charges, Exchange charges, and DP charges. The cost of buying and selling ETFs can also vary depending on the broker and the fund’s trading volume.

Mutual Funds: While active Mutual funds often have higher Expense ratios, do not have trading commissions, as they are bought directly from the fund house. However, some Mutual Funds charge an Exit load when you redeem your units before a specific period, which can add up over time.

Tax Efficiency

Another critical area where ETFs and Mutual Funds differ is in their tax efficiency.

ETF: ETFs tend to be more tax-efficient because their structure allows investors to buy and sell without triggering capital gains distributions. The trading of securities happens by the Fund Manager without investor involvement.

Most ETFs track an index and don’t frequently buy or sell securities within the fund by minimizing taxable events.

Mutual Funds:  Mutual Funds can generate capital gains taxes more often due to the frequent buying and selling of securities within actively managed funds. Even if the market value of a mutual fund falls, the sale of units of the funds might still trigger a tax liability for investors.

Minimum Investment and Flexibility

ETFs: ETFs can be purchased in whole shares, meaning there is no minimum investment requirement beyond the price of one share. This flexibility makes investors an attractive option for investors with smaller budgets who are even new to the market.

Mutual Funds: Mutual Funds often require a minimum initial investment for Lumpsum as well as SIP, which can range from a few hundred to thousands of rupees. However, all funds allow for purchases in fractional units, which can be helpful for investors using SIP to build wealth over the period.

Differences Between ETFs and Mutual Funds

When to Consider ETFs?

ETFs are ideal for investors seeking low risk and low return. Because it has

• ETFs have low-cost exposure to broad indices or specific sectors, such as technology or Banking.
• Intraday trading flexibility to capitalize on short-term price movements.
• Tax efficiency, especially for investors who are falling into higher tax brackets.

When to Consider Mutual Funds?

Mutual Funds may be more suitable for investors who want to increase or grow their wealth. While Mutual funds consist of

• Mutual funds have active management to outperform the market by generating additional Alpha with a skilled fund manager.
• Investors looking for Goal-based investing for long-term objectives like retirement or education savings can go with Mutual funds.
• Mutual Funds have access to diverse asset classes such as debt or hybrid funds, which cater to conservative investors.
• Mutual Funds can invest using SIPs for disciplined and consistent wealth-building over time.

Performance and Growth of ETFs and Mutual Funds

ETFs and Mutual Funds both have strong presences. ETFs like the CPSE ETF and sectoral ETFs offer exposure to public sector enterprises and specific growth sectors. These instruments are growing in popularity due to their cost-effectiveness and ease of trading.

Mutual Funds continue to be a favored choice for long-term investors, offering flexibility through active management and a variety of asset classes. 

Funds focused on sectors like healthcare, infrastructure, and financial services have been performing well, by generating high Alpha driven by government policies and sectoral growth.

How to Choose Between ETFs and Mutual Funds?

When choosing between ETFs and Mutual Funds, you must consider the following.

• Investment goals: Do you need broad market exposure ETFs are the best investment. Looking more targeted, goal-based investing it’s better to go with Mutual Fund.
• Risk tolerance: ETFs often mirror market volatility, while Mutual Funds offer more diversification across various asset classes.
• Costs: ETFs generally have low costs, while some Mutual Funds have high Expense Ratios even though it is better for consistent investors through SIPs.
• Time horizon: ETFs are often suited for investors looking for shorter-term strategies, whereas Mutual Funds are better for long-term, goal-driven investments.
• Tax considerations: ETFs tend to be more tax-efficient, making them an attractive option for high-tax investors.

Conclusion

Ultimately, ETFs and Mutual Funds both have distinct advantages. ETFs are cost-effective, tax-efficient, and flexible for investors seeking diversification and short-term investment. Mutual Funds offer active management, access to diverse asset classes, and proper balance in various asset classes and can be ideal for long-term goal-based investing.

In late 2024 and early 2025, as markets become more volatile and complex, investors should aim for a balanced approach incorporating both ETFs and Mutual Funds into their portfolio to diversify across multiple asset classes and strategies. This can help mitigate risks while maximizing potential returns, ensuring a more robust and resilient investment strategy while markets are at landscape.