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Index Funds vs. ETFs: A Quick Look

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Index Funds vs. ETFs: A Quick Look
Prateek Mehta - 27 August 2019

Index Funds and ETFs are two popular methods of passive investing. Passive investing is an approach which generates returns through investing in stock and bond market indices. They are contrasted with active investing of the likes of mutual funds, pension funds and ULIPs. The fund manager of an actively managed fund aims to outperform a chosen index through regular buying and selling of securities. Returns from active funds could be higher or lower than the index. In contrast, a passively managed fund aims to mimic an index. It aims to maintain the same stocks and weights as its index. Returns from these funds are at par with the index or market returns.

Index Funds

Index funds are mutual funds that replicate the performance of a benchmark index. The weights of the securities in the portfolio match the index. The risk and return of the fund match with the market solely based on the theory that the market outperforms any investment in the long term. They are priced based on Net Asset Value (NAV). Like other mutual funds, index funds are offered by Asset Management Companies (AMC). Both lumpsum and SIP investments are allowed in index funds. Minimum investment typically stands at ₹5,000 for lumpsum and ₹500 per month for SIP. Currently there are no bond index funds in India. Equity index funds are taxed like other equity mutual funds. In the short-term (less than one year), capital gains from index funds attract 15% income tax. If sold after a year of purchase, gains from index funds attract 10% income tax on gains above ₹1 lakh.

ETFs

Exchange Traded Funds (ETFs) is a basket of securities, that trade on an exchange just like stocks. Buying an ETF unit is equivalent to buying the stocks. They carry both NAV and a market traded price. There could be some difference between the NAV and the traded price of an ETF. The price of an ETF fluctuates during market open hours. The NAV on the other hand is generated only once per day. The minimum which can be bought is 1 unit. There is no option of doing an SIP in ETFs. Taxation on ETFs is like stocks or equity mutual funds. There are multiple kinds of ETFs available today in India – SENSEX/Nifty ETFs, sector specific ETFs, Gold ETF, Bond ETF, etc. ETFs are more popular among institutional investors than retail.

To understand ETF in detail, let us take the example of ICICI Prudential Nifty ETF. It aims to mirror Nifty 50 index. 1 unit of this ETF is equal to 1/100 of NIFTY 50. So when you buy 1 unit of this ETF, you are buying 1/100 of the weight of each constituent stock of NIFTY 50. On 15-July 2019, NIFTY 50 closing price was 11588.35. 1/100 of this would be 115.88. Now, ICICI Pru Nifty ETF closing price on 15-July was 121.32 whereas its NAV was 121.3549. Let us also see how closely ETF matches the index returns. 1 yr ICICI Pru Nifty ETF returns of 6.36% are just a tad lower to NIFTY 50 TRI returns of 6.45%.

Index Funds vs. ETFs

Index funds and ETFs both mirror the index. Their risk and return are like that of the index they follow. The similarity between these two ends here. ETFs and index funds differ in the way they are managed, priced, transacted and settled.

Pricing

Index funds are setup like a regular mutual fund. They can be bought and sold throughout a day at the same NAV. The NAV is updated at the end of the day. On the other hand, the price of an ETF fluctuates throughout the day based on trading demand and supply. Typically, the traded price of an ETF is lower than its NAV.

Expenses

The expenses in an index fund is the expense ratio of the fund which consists of base fees, management fees and distributor fees. The expenses in an ETF are expense ratio and trading costs. The expense ratio is lower than index fund and the trading costs are similar to that off individual stock traded on an exchange.

Liquidity

Index funds are highly liquid as a part of the assets are held in cash to meet the redemption needs of the investors. ETFs are not as liquid as index funds. ETFs can be sold only on the exchange and there needs to be a counter party to trade. In India, ETFs are yet to become popular and the trading volume of ETFs is low. This also returns is ETFs trading at a slight discount to their NAVs.

Transactions

Index funds can be purchased like any other mutual funds through an online distributor, AMC website or through offline agents. There is no need for a demat account to hold units of an index fund. ETFs can be bought and sold only through a trading cum demat account just like how shares are bought and sold. New ETF units are sold to institutional investors just like an IPO or FPO. Then, they reach the secondary market which enables retail investors to invest.

Tracking error

Index funds are more liquid than ETFs as a part of AUM is held in cash. But this leads to risk of tracking error in index funds. Fund manager tries to keep the error to the minimum so that the performance of the fund is closely matches the index. For ETFs the tracking error is less mainly because a large part of investments are not held in cash to meet redemption needs. But the risk in ETFs is the widening bid ask spread during volatile times.

Settlement time

Index funds transactions are settled in a day and hence give investors quicker access to cash following sale. ETF transaction settlement takes 3 days and hence takes more time for the investor to get the investment money back

Which is better?

Choice of investment always boils down to investor’s preference with respective to investment amount, horizon, liquidity and risk taking ability. Both Index Funds and ETFs have their benefits and drawbacks. Index Funds are simple and cheaper to manage, and hence attract lot of investors. ETFs are exposed to market volatility. Since ETFs do not have SIPs, investors should be self-motivated to invest in them. While for Index Funds, SIP is a convenient method to continuously make investments. For small value transactions, index funds would turn be cheaper overall due to zero fixed charges. To get a low value of ETFs, one needs to pay considerable fixed brokerage and demat account charges. For large orders, ETFs would turn out to be cheaper due to low Expense Ratio.

Conclusion

A passive fund provides low cost diversification to your portfolio. Index funds and ETF broadly serve the same objective. The choice between them is a matter of personal preference as described in the previous section. An investor could use index funds for diversified low-cost investing into major equity indices. The same investor could use ETFs for more nuanced low-cost investing into sectoral / commodity/ bond markets. Either ways, the investor gets access to low cost investing into financial markets.

The author is the Co-Founder and CEO, Upwardly.in

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