Imagine a bright-eyed youngster with a wish to invest, but all he has to call his capital for this purpose is ₹500. While the youngster’s motives might mean well, they might be somewhat under-funded. Most investors that wish to start young, often face this trouble. There’s only so much you can get as “pocket money”.
Another perspective on the “investment dilemma” is an investor’s risk aversion. Due to financial misinformation or just a lack of exposure to the world of investing, most people choose not to dedicate a large amount of funds towards this adventure.
As if this low investing capital wasn’t bad enough, this lack of funds causes other problems too. The little investment that is acquired with this money, is often non-diverse. As a result, the investors’ portfolios get exposed to risks that affect the company as well as its industry.
So what can these prospective investors do? Never invest? Or be forced to spend more than is available to them? Is there no resolution to this problem?
Well of course there is! After all, every problem exists to be solved, sooner or later. And the solution to today’s “investment dilemma” comes in the form of pooled investment vehicles.
Mutual Funds & ETFs: Two peas in a pod
Now the question that comes to mind is, “What is this pooled investment vehicle and Is gaadi ka stop ya stand kahan hai?”(you know? because vehicle=gaadi…) Well, the word “vehicle” here means an organisation that helps people enter the world of investment, even the ones with possibly insufficient funds to embark on this journey on their own.
And to explain how a pooled investment vehicle works, I’d like to remind you of the story of the father who taught his sons the importance of unity with a bundle of sticks. Going off of the story’s example, the individual investors’ smaller funds are similar to the sticks when they are divided. The smaller funds are weak and do not amount to anything significant.
This is where the pooled investment vehicles come into play. They bring together these multiple lonely, weak sticks of funds and consolidate them into, you guessed it, a pool of funds.
This pool of funds consists of contributions from thousands of people, united by their risk appetite by these organisations. And that is how, your small investment along with many others form an investment that is worthwhile and has potential that is much greater than the smaller investments alone.
Well, you alone can’t afford to buy different shares and diversify your portfolio but if thousands of people with 500rs can come together they can create a huge corpus for investment and that’s where the core of mutual funds is. A mutual fund involves a fund manager, who builds a portfolio of stocks in which they invest using the money they have collected from different investors. These investors think that investing in this fund category suits their risk appetite and can also help them achieve their financial goals.
Mutual Funds and ETFs: Key Differences
Now I know you were wondering why I kept explaining mutual funds but called it pooled investment. That’s because mutual funds are a type of pooled investment along with exchange-traded funds or ETFs.
In a way, you can think of mutual funds and ETFs as siblings. Now, you may ask, why do we say so? It’s because an exchange-traded fund is also a pooled investment vehicle but with a bit of a twist. The twist is that these funds are available on different exchanges like NSE & BSE, as the name suggests. This also means that you can buy and sell them as you would do with individual stocks in your portfolio.
Mutual funds and Exchange Traded Funds (ETFs) have a close resemblance. Both of these investment avenues are pretty alike in picking different assets to provide and amplify the perks of diversification. Though these avenues consist of the same ingredients, their management makes all the difference. How so? We’ll let you know as we move forward with this blog.
Mutual funds are usually actively managed as the fund manager has all the rights to make alterations in the portfolio of stocks to beat the returns from the market.
However, it’s different when it comes to ETFs as the fund managers of these funds have no power to pick and dump stocks as per their will, which is also why the management of ETFs is referred to as passive management.
Since mutual funds are actively managed, the fund manager can have a variety of stocks from the same or different sectors as per the category of funds. For example, in the case of thematic mutual funds, if a fund has the theme of technology, the fund manager can allocate all available resources to the tech giants and the emerging ones.
However, the picture changes as we move towards ETFs since they are simply based on a particular market index which restricts the fund manager from making any alterations. They just have to make sure that the stocks or any other asset present in an ETF under their management has the same weightage as they have in an index that has been replicated or tracked.
There are two types of mutual funds, open-ended and close-ended. In open-ended mutual funds, investors can simply invest as much as they want. The fund can increase their investments in shares as much as they want in addition to the benefit of withdrawal as per the will of an investor.
In the case of close-ended mutual funds, the funds are only allowed to issue a specific number of shares, limiting the investable amount for investors and restricting withdrawals. In a close-ended mutual fund, the fund house allows redemption for a specific period of time known as an interval.
Still, these mutual funds are not allowed to be traded on different exchanges. Mutual funds hold several shares from different or same sectors in whatever proportion they want to, using the money they receive from investors via SIPs or Lumpsum investments.
On the other hand, ETFs are allowed to trade on different exchanges just like stocks of individual companies within the trading hours.
As most mutual funds involve active management, they have higher fees and higher expense ratios as the fund manager has to always be on the edge of the chair looking out for stocks to beat the markets.
On the other hand, since the fund managers of ETFs have to just replicate a particular index and because they don’t have a job to beat the markets, their expense ratios are very low compared to that of a traditional mutual fund.
Both mutual funds and ETFs are exposed to various risks. Some are shared, while few are intrinsic or specific to them. One such risk arises from stock selection by a fund manager.
This risk exists because the fund manager is the supreme decision-maker in the case of mutual funds. For instance, if a manager believes that increasing investment in Reliance shares can be beneficial in the future, no one can stop them from doing so. In the unfortunate event that the share price of Reliance plunges, investors shall incur losses due to the fund manager’s incorrect decision.
This isn’t the case with ETFs since a fund manager has no power to pick shares according to his will, and instead, they just have to maintain the portfolio in coherence with the index that is being followed or replicated.
To sum up this entire discussion, mutual funds and ETFs are very similar because they are both investment options that collect smaller sums from various investors to create a large corpus of funds.
But that is about where the similarities end as mutual funds and ETFs are very different in their internal functioning. This causes their performance to differ, which in turn affects your finances.
While mutual funds are more flexible than ETFs, this flexibility comes at the cost of slightly greater risk borne by mutual funds. While this risk factor might paint mutual funds negatively, the risk comes from investing in high-return stocks that give mutual funds the possibility to earn greater returns than ETFs.
A difficulty often faced by investors is deciding how to split their capital in what instruments. With Recipe’s Financial Appetite tool, you can finds the ideal allocation of your funds and find what percent of your wealth should be invested in various financial instruments.
Source: Financial Appetite on Recipe
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Source: Financial Appetite Result on Recipe
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Thus, even though one cannot definitively suggest which pooled investment vehicle is better than the other, knowing one’s appetite and available funds seems to be a great first step.
Which one do you prefer? Tell us in the comment section below.
Until then, Happy investing :)