Previously, we’ve covered the basics of investing in mutual funds as well as the different plan types, and different ways in which to invest in them. While these are actively managed funds, there is often an ETFs vs Index Funds debate when it comes to passively managed funds.
Broadly, they are similar to the extent that both track the performance of an Index, like the Sensex of Nifty. Both are passive funds, meaning the fund manager does not manage allocation of funds actively.
An ETF is like an Index Fund, and an Index Fund is like a mutual fund. Confused? Let’s get to know them better 🙂
Exchange Traded Fund (ETF)
These are securities that are traded like a basket of stocks which replicates the composition of an Index, such as the Nifty 50 for eg. Unlike regular open-ended mutual funds, ETFs can be bought and sold throughout the trading day like any stock. There are different types of ETFs like Gold, Index, Banking, Liquid depending on the index they’re replicating.
An Index Fund is a mutual fund that tries to mirror a market index, like Nifty or Nifty Jr. by investing in the stocks that comprise that index in the same proportion as the weightage of those stocks in that index.
While the basic premise of both is the same, there are several differences that you should be aware of, as below:
ETFs are traded on an exchange, which means you need to have a demat & trading account in order to buy an ETF – the same way as when buying shares. Minimum purchase must be for one unit and prices are shown live as of the time of purchase. ETF prices depend on demand and supply on exchanges.
Index funds can be bought via a distributor / advisor or directly from the fund house and can be bought lump-sum or via a Systematic Investment Plan (SIP). Minimum purchase in any mutual fund is usually Rs 5000 (lump-sum) or Rs 500 (SIP), which will vary across funds. Price is not live – the net asset value (NAV) is determined at the close of day, on the basis of which units are allotted.
Sale / Redemption
ETFs are sold from your demat account during regular trading hours, and you can sell some or all of your units. However, do keep in mind that this depends on the liquidity of your ETF – there are chances you may be unable to find any buyers for it at the time you want to sell.
Index funds can be redeemed via a distributor or the website of the fund house if bought directly. The rate applicable will be determined at close of day and the redemption is guaranteed since the fund is buying back your units.
Buying or selling of ETFs will incur commission / brokerage and other costs, the same way as with stocks.
Whether an Index Fund is bought via a distributor (Regular Plan) or directly, there is an expense ratio – higher in the former case and lower in the latter. An exit load may also be charged if you redeem before the predetermined exit period, for eg 1% if redeemed within 90 days. This may differ across funds.
Tracking Error measures the deviation of an index fund or an ETF’s return from the underlying benchmark, which will impact overall returns.
In the case of ETFs, this is negligible since they don’t have to keep aside any funds from the liquidity perspective. When you sell an ETF, you receive payment from the buyer. The fund’s assets remain as-is. .
In Index Funds, it is different. When you sell units, the payout happens from the fund itself, so the fund manager has to make a provision for enough cash for such requests, as well as commission to brokers and distributors, as compared to an ETF. This in turn affects the overall returns from the fund.
So, which one is better to invest in?
In India, passive investing has yet to pick up in a big way compared to more developed markets, and actively managed funds are far more in demand than ETFs or Index Funds.
If you feel you’re capable of picking the right stocks or mutual funds and outperforming the market, you don’t need to invest in a passive instrument that just mirrors an index. However, if you want minimal exposure to stocks/volatility and want to keep costs low over the long term, an ETF or an Index Fund is the way to go. Choose wisely, based on the factors mentioned above.