Investing in India has come a long way thanks to the development of online investment platforms. Today, more people in the country are investing their hard-earned money in mutual funds than ever before. While financial literacy has increased in India, a large section of the society still doesn’t have the time to manage their investments actively. This has popularised passive investment options like index funds and ETFs (Exchange Traded Funds).
In the case of passive funds, experienced finance experts, known as fund managers, manage the fund's portfolio, allowing the funds to generate comparable returns to the index they’re mimicking. Index funds and ETFs are both popular options and have the potential to generate similar benefits. So, which one should you choose? To know which fund best suits your interests, let’s compare ETF vs index funds and understand their major differences.
Index funds are passively managed mutual fund schemes. The fund managers do not actively choose the stocks or securities in which the investments are made. They invest in exactly the same stocks as the index they follow, even matching the weightage of each investment at par with the index. The fund manager's job is to maintain the fund's portfolio as closely to the index as possible at all times.
These funds offer comparable returns to popular market indices like NIFTY 50 or SENSEX 100. They’re like any other open-ended mutual fund scheme with the added benefit of allowing investors to invest in the top companies and access a broader market. These schemes also have a lower risk than investing directly in stocks, making them very popular among investors.
Here are the top characteristics of index funds investors should know before choosing the best index funds to invest in 2024.
Dual Benefits: Index funds allow investors to earn both dividend and growth options. Based on your risk appetite, you can choose which return best suits your financial goals.
ETFs (Exchange Traded Funds) are also passively managed mutual fund schemes. However, they differ from index funds. One of the main differences is that investors need a DEMAT account to invest in ETF schemes. This is because ETF funds trade in the intraday stock markets and clock returns at the end of the day.
These funds are very transparent, and investors know exactly where their investments are allocated. In fact, investors can get daily intimation of the complete holding information of ETFs every day as the funds are traded on exchanges. Much like index funds, ETF returns are subject to stock market performance as all transactions are performed in real-time. Some examples of ETFs include bond, currency, industry, and inverse ETFs.
Before you learn the differences between ETF index funds, let’s understand the important characteristics of ETFs.
To help you determine whether you should invest in ETFs or index funds, here are the major differences between the two described in a tabulated form.
|
Criteria |
Index Funds |
ETFs |
|
Structure |
Index funds function like traditional mutual funds, and they aim to offer comparable returns to the index they’re replicating, such as NIFTY 50 or SENSEX 100. The pricing of index funds is calculated based on the NAV (Net Asset Value), calculated at the end of the trading day. All index fund transactions are executed using the calculated NAV. |
ETFs, unlike index funds, are traded on the stock exchange throughout the trading day like individual stocks. This allows investors to buy and sell ETF units at any time during the trading day at the current iNAV. The iNAV or Intraday Net Asset Value is the actual worth of an ETF unit during the trading day. Simply put, ETFs offer investors the flexibility of intraday trading, unlike index funds. |
|
Costs |
Index funds have a slightly higher expense ratio compared to ETFs. However, index funds do not have other associated costs like brokerage fees, trading costs, and bid-ask spread. |
ETFs have a lower expense ratio compared to index funds. However, ETF investors should consider other associated costs like trading fees, brokerage, and bid-ask spread when calculating the total expense they’ve to bear. |
|
Tracking Errors |
Index funds are subject to more tracking errors due to their structuring, which involves keeping a portion of their investments in debt instruments to meet investor redemption requests. |
ETFs are able to follow the index they’re tracking with higher accuracy as these funds do not need to maintain cash reserves at par with index funds. Investors purchase ETFs directly from the stock market, which allows mutual fund houses not to be involved in the process. This helps ETF funds not maintain reserved investments in debt instruments. |
|
Liquidity |
Index funds offer liquidity, and mutual fund houses ensure that buy and sell requests are honoured. |
ETFs can offer even better liquidity than index funds as they’re traded throughout the trading day. If liquidity is important to you as an investor, don’t invest in low-liquidity ETFs. |
|
DEMAT Account Requirement |
Investors do not require a DEMAT account for investing in index funds. |
Investors must have a DEMAT account to invest in ETFs. |
|
SIP Investment |
Index funds allow investors to invest using SIPs |
ETFs do not allow SIP investments |
|
Best Suited For |
Index funds are best suited for risk-averse investors who want to match the market returns of popular indices with minimal investment management. These funds are best suited for long-term investors. |
ETF investments are best suited for investors who know how to use DEMAT accounts and understand the concepts of price-NAV differences and ETF liquidity. |
ETFs are traded throughout a trading day, which can lead to price deviations from their NAV (Net Asset Value) due to variable demand and supply. This is why investors should always check the price NAV gap in ETFs before investing. To make tracking price changes during a trading day easier, SEBI has made it mandatory for mutual fund houses to publish intraday NAVs or iNAVs. The iNAV (Intraday or Indicative Net Asset Value) is a metric used to determine the fair value of an ETF during a trading day. This metric can help investors understand what one ETF unit is actually worth at any time during a trading day.
If you’re wondering why the returns were not used as criteria for comparing ETF vs index funds, this is mainly because they offer similar returns when investors are not actively managing their ETF portfolios. If you were to look closely, ETFs offer slightly higher returns in comparison. However, ETFs also bear various associated costs, which makes the return difference between these two funds almost negligible. So, if returns are not comparable, how do you decide whether to invest in index funds or ETFs? Deciding between index funds and ETFs should be based on your risk appetite, investment horizon, understanding of stock trading, and overall financial goals.
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