Choosing a passive investment idea: Index funds v/s ETFs | Motilal Oswal

Index funds versus ETFs: Choosing the right passive investment

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Passive investing, as the name suggests, is a passive approach to investing in equities. Remember, you can invest passively in a variety of assets but for the sake of simplicity let us stick only to equities. The purpose of passive investing is to mirror the index and not to beat the index and hence it is a more conservative and lower risk approach to investing in equities. That brings us to the next question, how to invest passively in the Indian context?

Two popular instruments of passive investing.
The two most popular instruments of taking a passive exposure to equities are through Index Funds and through Index ETFs. Let us understand these two products in greater detail.
An index fund is like any normal mutual fund scheme. The only difference is that the fund manager just creates a portfolio that exactly replicates an index (Sensex or Nifty). There is no element of stock selection in the index fund. The only effort the fund manager puts in here is to ensure that the tracking error is kept at the bare minimum so that the performance of the index fund mirrors the performance of the index as closely as possible.
An Index ETF, on the other hand, is fractional shares of the index. An ETF is almost akin to 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. If the Nifty ETF is 1/100th fractional unit then one unit of the Index ETF will roughly be available at Rs.99.34 assuming the Nifty level at 9934. Of course, in reality there will be a minor divergence to reflect costs.

Making a choice between Index Funds and Index ETFs: What you need to know

The most important thing to know is that when you buy an index fund from an AMC it adds to the AUM of the Fund. On the other hand, when you buy an Index ETF you do not add to the AUM of the ETF, but you can buy or sell only if there is counter party to the trade. So, availability of market liquidity is paramount to the choice of an index ETF.

An index fund being a mutual fund is available for purchase or sale only at the end of day (EOD) NAV. You can buy index funds during the trading hours. Index ETFs, on the other hand are available to buy and sell during the trading hours at a price that reflects the Nifty fraction as closely as possible. This gives greater flexibility to the Index ETF buyer.

Expense ratio in an Index ETF is much lower compared to the index fund. For example, in India if a normal index fund has an expense ratio of 1.25% then an index ETF would have an expense ratio of just about 0.35%. However, there is a catch. Since ETFs are bought and sold on the exchange like any other stock, additional costs like brokerage, STT and statutory charges need to be factored in to get the correct picture.

Both the Index ETF and the Index fund run the market risk or Beta as we popular call it. However, there are two additional risks you need to wary of. Firstly, there is the tracking error risk which is higher in case of index funds compared to ETFs as index funds need to keep larger cash balance to handle redemptions. But Index ETFs run a higher risk of bid-ask spreads widening when markets get volatile.

One of the most popular methods of investing inequity funds is through the systematic investment plan. This gives the added benefit of rupee-cost averaging which lowers your average cost of owning the units. All mutual funds allow the benefits of SIPs and SWPs. However, when it comes to Index ETFs, the benefit of SIPs is not available as it is like a closed-ended fund. That becomes a challenge from a long term financial planning perspective.

There is also an interesting difference between index funds and index ETFs in the way the dividend pay-outs are managed. For example, in case of ETFs since it is like a traded stock the dividends are directly credited to your registered bank account. This again becomes a hassle from a long term financial planning point of view. In case of index funds, you can opt for a growth plan or a dividend reinvestment plan where the dividends are automatically substituted by units. In case of ETFs this reinvestment will have to be done manually.

On the taxation front, there is not much to choose between the two. Like in case of index funds, Index ETFs also are charged STCG at 15% and LTCG at 0%.

The two most important criteria you need to consider when making the choice between Index ETFs and Index Funds are costs and liquidity. If liquidity is easily available in the secondary markets without too much of a basis risk, then the lower costs will work in favour of the Index ETFs.

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