Let us have a look at some of the differences between these two investment options:
Let us understand the difference in more detail with an example :
Let us assume that you and 3 of your friends are creating the very first mutual fund in the world, each of you has $10,000 to invest but don’t have a time and knowledge about where to invest?
So you will hire a fund manager who will manage your money and invest that money in the securities such as stocks, bonds, short-term debt etc. Usually, the Mutual Fund Managers charge higher fees which results in additional costing.
In order to keep track of who have invested how much the mutual fund manager will issue shares of worth $100 to 100 shares/investor. Now, this value of $100 is known as NAV of the mutual fund. You can refer image below :
The beauty of this system is that any investor can join the fund and invest based on their appetite and the fund manager will issue them shares on the current value of shares. But the problem here is that mutual funds have high cost and fewer tax benefits.
But since no layman investor creates their own fund they invest in existing funds but the process is whole same. The investor invests money in mutual funds somewhere in the day by simply placing a buy order through their broker or they directly buy it from Mutual Fund Company.
While placing an order investor is not aware of the latest price or NAV of Mutual Fund, it makes mutual fund less transparent.
Then the money goes to Mutual Fund Company and fund manager calculates the amount invested and value of existing assets based on that the manager issues shares to the investor.
The next morning the manager interacts with you sends you shares, emails your perspective and then he goes to the market and buys securities with your money, this process at least take one to three days. This process adds additional cost which increases the expense ratios of a Mutual Fund Company.
Whereas ETF Funds works differently, to buy an ETF share unit you just simply place buy order with your broker.
Now, here in ETF Fund,you do not buy shares directly from ETF Fund, you buy it from another investor. There will be an investor who is ready sell the shares to you and once both the prices match shares get credited to your account.
Now what happens here you don’t have to wait until one day to shares to be credited to your account. You just go through bid and ask prices and place an order and the transaction is completed once the seller is ready to sell that price. Here, the interaction between an investor and ETF Fund is almost negligible which reduces the additional work of ETF Fund, hence lower expense ratios.
ETF trading occurs during market hoursso you can see the latest price of a share, the pricedoes not update at the end of the day, unlike mutual funds. You can buy and sell the shares within the day or can hold it for the long term. You can even short sell the shares of ETF for intraday trade.