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How to make a choice between Index ETF and an Index Fund

When you initially become an investor, you will have to learn some fundamentals of investing. This includes learning about the distinction between an ETF (exchange traded fund) and an index fund. An index fund is usually a passive kind of investment channel and constitutes investment through a mutual fund. That is not the main point of difference between an index fund and an ETF. An ETF is also a fund, but on the whole, it is considered more flexible than an index fund. The trading is easy to do and conveniently, you can trade in ETFs as simply as you trade in stocks.

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 fund and an index ETF (Exchange Traded Fund)? Let us look at the difference between an ETF and an index fund and gauge which is better: an ETF or an index fund.

How do an index fund and an index ETF compare? What is the difference between an ETF and an index fund?

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 with the index returns. But what is the difference?

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. In this respect, investors are not at the mercy of the fund manager’s opinions, and advice. The human bias is kept away. However, the fund manager can give investors the convenience of doing all the hard work. Investors have to just enjoy the returns, if any. 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. If errors are high, that means the fund is further aligned from the index fund which it should mimic as closely as possible. Index funds are open to purchase and redemption at any point of time and the AUM (assets under management) of the index fund keeps changing.

ETF vs Index Fund

An Index ETF, on the other hand, is composed of fractional shares of the index. An exchange 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. Here is where the liquidity aspect of ETFs comes into the picture. This aspect of ETFs also facilitates the ease of their use in trading and investing.

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 an Index Fund vs an ETF

When you buy an index fund from an AMC (asset management company), 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 go 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 vs index fund is that the Expense ratio in an Index ETF is much lower than an index fund. In India generally index funds have 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 benefits 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.

Key Highlights About the Difference between an ETF and Index Fund

Many investors feel that ETFs score higher in the popularity charts than index funds. This is especially suitable for fresh investors and those who are still inexperienced investors. With ETFs, you can easily buy them in small sizes and with less hurdles than you would index funds. Furthermore, ETFs strike a convenient note as investors can avoid any special paperwork that may be involved with a regular mutual fund like an index fund.

Mutual funds, whether index funds or any other, are investment vehicles that are made up of pooled funds. These are managed by a mutual fund professional, the fund manager. Although, with an index fund, managers have little to do but to track the fund so it remains aligned with the index of the fund, there is still scope for risk. Fund managers may not be attentive enough and if the tracking error is high, investors stand to make losses.

ETFs are mainly baskets of securities. These can be traded on exchanges like stocks, purchased and sold anytime investors wish. They are lower in cost, and this makes them good bets for initial fresh investors. ETFs also prove to be more efficient where taxation is concerned.

An Investor’s Choice

Knowing the difference between an index fund and an ETF lets you know about the advantages and disadvantages of both kinds of investment too. With this knowledge, you can make an informed decision about your investment. Both investment avenues are long-term strategies of investment and rather conservative, according to analysts. In other ways, too, both kinds of funds are similar in that they are designed to mainly mimic the performance of different other assets. However, depending on their differences, you can select either one that suits your needs.