Know your investment: MFs v/s ETFs

Mutual Funds are the Indian middle class’ favorite instrument after deposits, land, and gold. A person with a modest salary they are an ideal vehicle for growth. They give the small investor the benefit of investing in the stock market while distributing the risk over a basket of investments. Most MF companies offer various structured products, ranging from equity-based to debt-based, with all permutations of hybrids. In recent times though, their (slightly) more colorful cousins, the Exchange- Traded Funds, have started appearing (the first was launched in 1993), and I am often called up to explain the difference. So here I clear the air.

Both operate in the same way. They collect money (through the purchase of ‘units’) from investors, small or big. The minimum one needs to invest is just INR 500, making this an accessible market to enter. Once a new fund offering (NFO) has gathered enough money, its manager will invest it in the kind of instruments advised. For example, a blue-chip MF will invest in blue-chip stocks. This sets out expectations very clearly at the start — the fund’s fate will track the future of the underlying stocks, with not too much volatility but not very big profits. A fund based on riskier scrips or sector-wise paper will behave accordingly.

These are the main difference between an MF and an ETF:

1. A mutual fund can only be bought from the AMC and has to be sold back to it. On the other hand, an exchange-traded fund is listed on the exchange and can be traded like any additional scrip. The latter’s advantage is that its price is transparent since it is a weighted average of all its underlying stocks. The former, on the hand, has a net asset value (NAV) of the day decided by the AMC, over which the owners of the units have no power.

2. The NAV is set daily, so an investor can only buy and sell once daily. On the other hand, an ETF can be bought, sold, and bought back on the same day. It can therefore be ‘shorted,’ which an MF cannot.

3. ETFs have no initial lock-in period, whereas MFs do. The AMC charges an administrative fee (aka a penalty) for selling units of an MF beforehand.

4. An ETF is not dynamic (though that is changing). One constituted, it doesn’t change. On the other hand, an MF is actively managed by a fund manager, and its composition changes depending on her/his assessment of the market.

Many ETFs are simply mirrors of the index of the bourse they are listed on, so the underlying stocks are the same as those that make up the index. This makes the ETF move more or less in lockstep with the index (depending on proportion). Interestingly, an MF may hold some of its holdings in ETFs, though the reverse is not that common.

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