What do investment funds and Exchange Traded Funds have in common and what distinguishes them? A brief guide to understanding the characteristics of each asset.
ETFs and mutual funds are among the most widely used instruments by investors and savers. They have some similar characteristics: low entry thresholds, they appeal to a wide audience and are diversified.
However, they also have many elements of diversity, with some advantages and some disadvantages. As always, when it comes to investments, there is no right and wrong solution. It all depends on the objectives, time horizons and needs of the investor.
But let’s start by understanding how these different types of investments differ.
What are mutual funds and ETFs
Mutual funds are vehicles that collect capital from a pool of savers, investing it in financial assets as if it were a single asset. Mutual funds always belong to an asset management company, which decides how to allocate the capital.
ETF stands for Exchange Traded Funds. These are funds with low management fees, traded on the stock exchange just like a normal share. They are characterised by the fact that they replicate the performance of a reference index (or set of indices) and are therefore passively managed instruments.
Advantages and disadvantages of ETFs
ETFs combine high liquidity with diversification. Buying a share in an Exchange Traded Fund does not make the investor a ‘partner’, but allows him to bet on a basket by participating in its performance. In other words, the ETF allows investors to invest simultaneously in hundreds of securities, thus reducing risk and volatility.
ETFs also have the advantage of being simple and transparent. Although they do not have the same degree of customisation as a share portfolio, the choice of ETFs is in fact defined according to the risk appetite and investment horizon of the investor who can, at any time, observe the composition and performance of his investment, and liquidate it if necessary.
ETFs and mutual funds: differences, advantages and disadvantages
ETF management is called ‘passive’ or ‘indexed’ because it aims to replicate the performance of an index. It therefore has less flexibility than a mutual fund.
This leads to lower management costs, but also to another characteristic. An ETF, by its very nature, does not have the objective of beating the market, i.e. it will not make you lose but neither will it make you earn more than the benchmark.
Advantages and disadvantages of mutual funds
Mutual funds aim to build diversified portfolios (equity, bond or mixed). Compared to a direct investment in only one asset class (e.g. in shares), they are therefore instruments that reduce risk and increase efficiency.
Mutual funds are managed by an asset management company, which decides how to allocate the capital raised. The managers change and supplement the portfolio continuously, depending on the market phase.
To do this requires great expertise, continuous updating, and a lot of time to devote. This is why mutual funds have – compared to ETFs – higher costs on average. At the same time, however, the active search for new opportunities opens up an option precluded to Exchange Traded Funds. Mutual funds do not replicate an index and, as a result, can outperform the reference markets.
Finally, there is a technical difference. While ETFs can be traded at any time and at market price (as is the case with shares), the value of a fund is usually only defined once a day, at the end of the stock exchange session.
A final distinction in this regard: mutual funds can then be open-ended, when it is possible to subscribe and liquidate one’s share at any time, or closed-ended, when subscription is limited to a defined period of time.
Read also: World stock market indices: what they are and what they measure