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?
The asset allocation of an index fund tries to replicate that of a popular index that it is trying to emulate. As index funds are not having liquidity of their own, hence they invest more in liquid securities. Therefore, index funds having tracking errors. The deviation of the returns that an index fund would generate from the returns of its underlying index is directly proportional to the tracking error.
How to choose between an Index ETF and an Index Fund?
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 are to either opt for an index fund or an index ETF. The purpose of passive investing is to mirror the index and not to beat the index. Now, the question is how to choose between 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 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. 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
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 a 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) 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.