Passive investing is a conservative approach as it seeks to minimise the risk by mirroring an index instead of trying to outperform it. Index funds and ETFs are both passive investment instruments and economical as no active fund management is involved. But both are different in many aspects, so it is crucial to understand their differences to make the right choice.
An index fund replicates an index (e.g., Sensex or Nifty) and does not undertake stock selections. The fund manager’s sole task is to minimise the tracking error and ensure the fund performs closely with the index. Index funds track broader market indices like NIFTY 500 and theme-based indices like Nifty Next 50, which includes the 50 large-cap stocks ranked after NIFTY 50. Thus, they also achieve the objective of diversification.
On the other hand, ETFs invest in stocks, bonds, and derivatives and are traded on the stock exchanges. They also follow a benchmark index to replicate the performance. ETFs behave like mutual funds as they collect money from investors, but they also have the characteristics of a stock as they trade on the stock exchanges. Their prices also fluctuate during trading hours. To invest in ETFs, you need to have a demat account. But fund houses now allow investors to invest in ETFs through the fund-of-fund route. Unlike index funds, ETFs do not offer systematic investment plans (SIPs) but act like closed-ended funds. Like index funds, ETFs provide diversification, such as those based on the BSE 500, representing the country’s largest 500 companies. ETFs are also available with gold, commodities, banks, and healthcare themes.
Both ETFs and index funds carry market risk. However, there are additional risks to consider. Index funds have a higher tracking error risk due to the larger cash balances required for handling redemptions. Index ETFs face higher bid-ask spread risks during market volatility, representing the difference between the highest buying price and the lowest selling price. Looking at returns, it is evident that silver ETFs and bank-themed ETFs have outperformed competitors, generating over 38 per cent returns.
Cost Considerations And Other Key Differences
Index ETFs are known to have lower costs compared to index funds. For example, the expense ratio of Aditya Birla Sun Life Nifty 50 ETF is 0.05 per cent, whereas the index fund from the same AMC, Aditya Birla Sun Life Nifty 50 Index Fund, is 0.60 per cent.
Index funds are traded at the end of the day (EOD) NAV price. In contrast, index ETFs can be bought and sold during trading hours, providing greater flexibility to buyers. If one's ETF has good liquidity in secondary markets, then the lower management cost can work in favour of the investor. But as ETFs are bought and sold on exchanges like regular stocks, they entail additional charges such as brokerage, and statutory fees, which should also be factored in when evaluating returns.
In the case of equity index funds or ETFs, the gains are taxed as short-term capital gains (STCG) or long-term capital gains (LTCG). LTCGs up to Rs 1 lakh per year are exempted from taxation. Gains over this amount are taxed at 10 per cent. On the other hand, STCGs are taxed at 15 per cent. Investors must consider the associated risks and costs to make informed decisions based on their financial goals and preferences.