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ETFs and MFs are same and yet different!

At the outset, kindly note that Mutual Funds (MFs) and Exchange Traded Funds (ETFs) are "conceptually same" but "operationally different" schemes.

A Mutual Fund Company creates a big pool of money by taking small amounts from many retail investors and allots them the units. It then invests this money in a portfolio of shares as per the scheme objective. This is known as a Mutual Fund.

A Mutual Fund Company takes money from large entities (brokers, dealers, institutions, etc.) called Authorized Participants (APs) and issues the units to the APs. It then invests this money in a portfolio of shares as per the scheme objective. Meanwhile, the APs sell these units on the stock exchange to many small investors (and get back the money they had invested initially in creating these units). This is known as an Exchange Traded Fund.

Since the units in both cases are created by investing a pool of money (in one case after collecting the money and in the other before collecting the money from many investors) to create a diversified portfolio of shares, conceptually both MFs and ETFs are the same. [Hence, if the portfolio of shares is same in both cases, e.g. an index-based fund, then the pre-charges returns too would be the same.]  

However, as they have been created differently, there are certain operational differences between the two.   

One. MF units are bought or sold directly between the MF company and an investor. On the other hand, ETF units are primarily bought or sold between two investors. So buying MFs is like buying shares in the primary market in an IPO/FPO directly from the company, while buying ETFs is like buying shares in the secondary market.

Two. Due to point 1 above, any sale or purchase of MF units changes its corpus. If you buy MF, the fund corpus increases and when you redeem your MF, the fund corpus reduces. Whereas in ETF, as two investors are merely exchanging the units among themselves, the fund corpus remains unchanged. (It increases only when AP creates more units by giving money to the MF Co. or reduces when an AP gives back units to the MF Co.)

Three. In MF, your purchase/sale price is the NAV of the fund at the "end of the day". In ETF, it is the price at which it is trading at the moment you buy/sell it (this is normally very close to the NAV, but may not be exactly equal to the NAV).

Four.  For ETF you need a demat account. For MFs you don't.

Five. Buying MFs does not have any entry load, except for some nominal transaction charges. And depending on the terms, even the exit load may be Nil. However, you will have to pay brokerage both at the time of buying and selling ETFs.

Six.  ETFs normally represent an index or a commodity. So ETF is generally a passive fund, where fund manager has very little role to play. Most MFs, on the other hand, are actively managed schemes. Consequently, in most ETFs, the fund management charges are lower than the MFs.

Seven. In ETFs there is no minimum specified investment amount. It all depends on the trading price/unit (as most of the time you can buy even 1 unit.). MFs, however, have a certain minimum specified amount.

[Just to share a good new with you all: Thanks to you all readers, 'Your Guide to Finance and Investments' has featured in the Rediff Books Top 10 Picks.]

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