ETFs and index mutual funds. Which one is a better choice?

ETFs and index mutual funds. Which one is a better choice?

As with everything in life, there are some things that you actively participate in and some others where you are passive. Active participation is when you are directly engaged and involved in the outcome. Passive participation is just the opposite, wherein you observe the proceedings without directly influencing the activities or their outcome.

When it comes to investing, the same principle applies. You can actively invest in specific stocks and create a portfolio or you can just invest in a basket of stocks selected by someone else using pre-determined rules. Some of the foremost amongst such investments, are ETFs and Index Funds. Both these asset classes originate from the same family of passive funds, which mirror the Index that they follow. They both aim to track the performance of the underlying Index as closely as possible.

Index Funds and ETFs are categorised under what is known as “Indexing.” Indexing involves investing in stocks of an underlying benchmark index on the same proportion and mirroring the portfolio. By being passive in approach, these instruments do not aim to beat the market or even the underlying Index they follow.

While ETFs and Index Funds are similar, there exist certain subtle differences. One of the key differences between them is that, unlike Index Funds, ETFs are listed on the exchanges, and an investor can invest in them at real-time NAV. On the other hand, an Index Fund is like any other mutual fund and one can invest in them without having demat account at the end of the day NAV.

Both Index Funds and ETFs have high levels of transparency as they cannot deviate from their chosen Index. ETFs offer daily portfolio disclosure. As an investor, you can choose to directly trade in ETFs on the stock exchange in small amounts. However, for investments upwards of certain amount, usually above 30 to 50 lakhs, you will need to go through an AMC. In the case of Index Funds, NAV is determined at the end of the day, and portfolio disclosures are either daily or monthly. Investing in Index Funds is akin to investing in any other mutual fund, where you approach an AMC with your investment and can start investing with as low as Rs. 1000.

The table below offers a holistic view of the benefits and subtle differences between the two asset classes –

ETFs Index Funds
Structure ETFs are mutual funds that track a specific Index and are traded on stock exchanges Index funds are just like mutual funds that track a specific index
NAV Real-Time End of the Day
Buying and selling On the Exchange for small unit sizes

Through an AMC for larger ticket sizes (usually between 25-50 lakhs)

Through Mutual Fund/AMC like any other mutual fund
Portfolio Disclosure Daily Monthly/Daily in some cases
Transparency of holdings High

(cannot deviate from Index)

High

(cannot deviate from Index)

Holding mode In Demat form Physical/Demat

Choosing between ETFs and Index Funds:

If you are looking for market liquidity or to gain from intraday trading, then ETFs would be the right option for you to consider. In the long run, both Index Funds and ETFs offer strong returns and are optimal for the diversification of your investment portfolio.

In terms of costs incurred in owning either ETFs or Index Funds, you need to consider the Scheme Expense Ratio that indicates how much the fund is expected to charge in terms of an annual percentage cost to manage your investment and the Tracking Difference which enables you to determine how efficiently the Index Fund or ETF is mirroring its underlying benchmark index.

Additionally, in the case of ETFs, you will need to consider the Impact Cost, which refers to the difference between the actual NAV and the price at which you buy the units on exchange. For example, if the ETF NAV is at Rs 100 and you purchase each unit at Rs 101, Re 1 is the additional or impact cost you pay to buy each unit. You will also have to factor in any brokerage or Demat charges that can be associated with the purchase of ETFs. Index funds do not have an impact cost as you directly buy from the AMC, and you get the units at actual NAV. If the difference in the expense ratio of an ETF and a similar Index Fund is not too high, then for most retail investors, Index Funds could be better as there are no additional impact costs or transaction charges to be incurred during investment or redemption. The other factor of comfort is that by investing via Index funds, you can easily follow the Systematic Investment Plan or SIP route, which could be slightly difficult to do in ETFs and you may need to depend on the broker to provide such additional facility or do it manually every month.

Depending on your investible corpus, time horizon, and taking the above subtle differences into consideration, you can choose to invest in either of these passive funds for long-term gains. Our recommendation would always be to seek the advice of a professional expert to help you make the choice that is most suitable to your needs.

(The writer is the Head – Product & Marketing, Edelweiss Asset Management Limited)

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