What are ETFs? Every question answered here

What are ETFs? Every question answered here

An exchange-traded fund consists of shares that constitute widely followed indices such as NSE Nifty 50 and BSE Sensex. If an ETF is tracking a particular index, then that index would contain the same stocks like that of the index, and their weightage shall also be the same. Additionally, the ETF may also invest in money market instruments for the sake of liquidity. ETF returns are generally predictable and will be close to what its underlying index earns.

Nevertheless, despite many ETFs track the same index, their returns will not be the same as their debt holdings differ, which affects their returns. The units of ETFs are traded on stock exchanges, similar to shares.

What are Index Funds?

How to choose between an Index ETF and an Index Fund?

How do an index fund and index ETF compare?

An index fund is like any normal mutual fund scheme. Instead of selecting stocks and trying to create alpha for you, the fund manager 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 funds are open to purchase and redemption at any point in time and the AUM of the index fund keeps changing.

An Index ETF, on the other hand, is 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 to always buy and sell it like equity shares in the market and hold it in your online Demat account. For example, currently, the Nifty is quoting at 11,450 so an ETF that 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

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) daily. On the other hand index, ETF prices vary on a real-time basis and the price also keeps changing frequently.

The big advantage in favor of an ETF is that the Expense ratio in an Index ETF is much lower than an index fund. In India generally, the 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 is 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 the case of index funds, you can opt for a growth plan where dividends are automatically reinvested.

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