Passive investing in the most basic sense is about putting your money in equity mutual funds. The catch is that it is only passive as far as you are concerned but not actually passive because your fund manager is still making active investment decisions. Two common ways of investing passively in the equity market is to either opt for an index fund or for an index ETF. The purpose of passive investing is to mirror the index and not to beat the index. The question, now, is how to make the choice between an index funds and index ETF (Exchange Traded Fund)? Let us look at the difference between ETF and index fund and gauge which is better ETF or index fund?
How do an index fund and index ETF compare?
To begin with both the index fund and the index ETF will essentially mirror an index. This index could be the Nifty, Sensex or any other index that you may opt for. The basic idea in both the cases is to mirror the index and give returns that are closely aligned to the index returns. But, how are they different?
An index fund is like any normal mutual fund scheme. The fund manager, instead of selecting stocks and trying to create alpha for you, just creates a portfolio that replicates an index (Sensex or Nifty). There is no stock selection in the index fund that the fund manager has to do. The only effort the fund manager puts in here is to ensure that the tracking error is kept at the bare minimum. The tracking error reflects the extent to which the index does not mirror the index (higher or lower). Ideally, for index funds the tracking error should be as low as possible. Index fund are open to purchase and redemption at any point of time and the AUM of the index fund keeps changing.
An Index ETF, on the other hand, is fractional shares of the index. An exchanged traded fund (ETF) is like a closed ended fund where the funds are raised in the beginning and then the ETF creates a portfolio of index stocks at the back-end to mirror the index. Once the portfolio is created the fund does not accept fresh applications or redemption requests. However, the ETF has to be mandatorily listed on the stock exchange so you can always buy and sell it like equity shares in the market and also hold it in your online demat account. For example, currently, the Nifty is quoting at 11,450 so an ETF which represents 1/10th unit of Nifty will be quoting in the market around the absolute value of 1,145. The divergence will be due to costs. This ETF vs index fund India debate is predicated on 5 factors.
5 factors that will drive your choice of Index Funds versus Index ETFs
When you buy an index fund from an AMC it adds to the AUM of the Fund and when you redeem your units the AUM reduces. The net effect each day will either increase or decrease the AUM. For an Index ETF you can buy or sell only if there is counterparty to the trade. So, liquidity is the key in index ETFs and their AUM will only increase when the value of the shares goes up.
An index fund purchase or redemption will be executed at the end-of-day (EOD) NAV. The NAV is the net asset value based on the market value of all stocks adjusted for the total expense ratio (TER) on a daily basis. On the other hand index ETF prices vary on a real time basis and the price also keeps changing frequently.
The big advantage in favour of an ETF is that the Expense ratio in an Index ETF is much lower than an index fund. In India generally index fund has an expense ratio of 1.25% while index ETFs have an expense ratio of about 0.35%. That is just the TER that is debited to the index ETF. In addition, when you buy and sell the index ETF you are also liable to pay the brokerage and other statutory costs like GST, STT, stamp duty, exchange fees, SEBI turnover tax etc.
Index funds score over index ETFs in the sense that you can structure a systematic investment plan (SIP) in an index fund. SIP has emerged as the most popular method of investing for retail investors. This gives the added benefit of rupee-cost averaging which lowers the average cost of owning the units. Since index ETFs are closed ended, the benefit of automated SIPs are not available to you. This is an area where index funds score.
Since ETFs are like traded stocks, the dividends are directly credited to your registered bank account. This is a hassle from a financial planning point of view as the dividends have to be manually reinvested. In case of index funds, you can opt for a growth plan where dividends are automatically reinvested.