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Mutual Funds vs. ETFs: Which one is right for you?
There has been a lot of talk in the recent past on Exchange Traded Funds or ETFs. One often hears of ETFs being considered as an alternative to mutual funds. Let us understand what ETFs are, how they work and which one, an ETF or a mutual fund, should you choose.
What is an ETF?
An ETF can be thought as index mutual funds but which are listed and can be bought and sold on stock exchanges, similar to shares or stocks. An ETF holds a bunch of stocks having the same composition as the underlying index.
For example, if BSE Sensex constitutes 20% of stock A by value, then an ETF based on BSE Sensex will also hold 20% of its amount in stock A. You can buy or sell an ETF on a real-time basis and their price or value keeps fluctuating throughout the day.
ETFs are a lot like mutual funds, except for the fact that they can be bought and sold in the stock market like shares. The type of mutual fund which can come closest to ETFs is an Index fund.
While both look similar, there some key differences between ETFs and Index mutual funds that you should know about.
Difference between Index mutual funds and ETFs
Index Mutual Fund Exchange Traded Fund
Passively managed. No need for minute-to-minute monitoring. Actively managed, needs constant monitoring just like stocks.
More suited to long-term investors. Ideal for short- to medium-term investors.
Lower cost structure with no entry or exit load. No entry or exit load, however incurs more cost due to brokerage commissions.
Capital gain tax at 15% if held less than a year. No tax for long-term investment (more than a year). Also subject to securities transaction tax (STT). Will be subject to capital gain tax, service tax (ST) and securities transaction tax (STT) as traded on a stock exchange.
Gives dividend (reinvestment or payout) or growth option to investors. Gives growth or dividend payout option. No option for automatic dividend reinvestment.
ETF or Index mutual fund? Which one to choose?
While both look similar, there are some key differences that make them suitable for different types of investors. The key deciding factors are the time horizon and the risk appetite. If you have a long-term time horizon, don’t have the expertise or time to monitor your investments on a day-to-day basis and have a low to medium risk appetite, then a passive investment is more suited for you through an Index mutual fund. However, if you are an active investor, looking at short- to medium-term gains, have time to monitor your investments on a daily basis and have the risk taking ability, you may want to invest in an ETF.
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Remember, the composition of stocks in an ETF mirrors its underlying Index.
Choose an Index mutual fund for a long-term investment if you have a low-to-medium risk appetite.
Mutual funds and ETFs differ in their time horizon, mode of investing, taxation, payout options and cost. Compare your investment requirements based on these parameters before making a decision.
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