ETF Vs Index Funds: Everything You Should Know Before Investing
ETFs or Exchange-traded Funds and index funds are two popular passive investment methods. While ETFs are active funds, Index funds are passive. An active investment puts an investor’s money at a fund manager’s disposal and allows them to make all the investment decisions. On the other hand, passive investment involves investing in securities and creating a portfolio similar to benchmark indices like Sensex or Nifty 50. So, if you are just starting out on your investment journey, here’s a list of differences between ETFs and index funds and things to consider before investing in either of them. Read on!
What is an Exchange-Traded Fund (ETF)?
Exchange-Traded Funds (ETFs) are a pooled investment avenue that functions like a mutual fund. But there is a difference between ETFs and normal mutual funds; ETFs trade on stock exchanges, unlike mutual funds. Investors can buy and sell units of ETF through a registered stockbroker. Investors can trade units of ETFs listed on stock exchanges, and the Net Asset Value of each ETF is dependent on market conditions.
What are Index Funds?
It is a passive investment avenue that could give you better returns in the long run. Considered one of the better options for long-term investments, index funds mirror a particular stock index, and the fund manager does not actively participate in creating a quality portfolio for their clients. They follow the index and invest in a majority of all stocks covered in that particular index. The weightage of each stock in their portfolio is closely related to the weights given to each stock in a particular index.
ETF vs Index Funds – The Key Differences
Here are some differences in the working and styles of ETF and index funds:
- Fund Management Style
A major difference between the two funds is the management style of the two. Index funds are passive funds as there is little initiative on the part of fund managers to create a quality portfolio. Instead, they rely on indices and follow them diligently.
However, ETFs can be passive or active investment instruments. Many ETFs in the markets focus heavily on a particular segment, and a team of fund managers actively participate in research to create a portfolio, which stocks to buy or sell. In addition, investors can find sector-specific ETFs like those focusing on gold, innovative technologies, pharmaceuticals etc. So ETF can be an active investment option as well.
Also read: Active Vs Passive Funds: Which one is right for you?
- Trading Style
Index funds behave exactly like mutual funds when it comes to trading. Investors can buy or sell index funds at the end of a trading session. On the other hand, ETFs work exactly like a stock, i.e. one can trade them throughout a trading day. NAV (Net Asset Value) of ETF fluctuates during trading hours as well.
- Minimum Investment Amount
ETFs are bought and sold in units. Investors need to buy or sell 7units, 10units, 25 units, etc., while trading in them. Suppose the price or value of one unit of an ETF is Rs. 50 then investors need to invest an amount in multiples of 50. Investors can even buy one unit by putting in Rs. 50 only.
Whereas one can buy or sell index funds in the amount of currency. They can buy an index fund by investing amounts like Rs. 500, Rs. 1,000, etc. The amount varies from one asset management company to another. So, in ETF, minimum investments are quite low than an index fund.
- Expense Ratio
Generally, the expense ratios of index funds and ETFs are lower than many active investment instruments. When one compares the expense ratios of these two funds, ETFs come with lower expense ratios than index funds.
However, investors must be aware of some additional inherent costs in ETF before putting in their money. First, an investment in ETFs can be made through a stockbroker or intermediary so, one has to pay commissions to these brokers for carrying out their transactions. Commissions include brokerage fees, taxes, and any charge levied. Second, the brokers charge a bid-ask spread. This is a transactional cost embedded in the price of an ETF.
Therefore, one must thoroughly compare the net expenses incurred between the two funds before investing.
- Liquidity
Liquidity signifies how quickly an asset is converted into cash and cash equivalents. In the case of index funds, one invests in an AMC, which uses those funds to buy securities of companies covered in a particular index. So, it is easier for them to redeem their units and get their money back.
In the case of ETFs, liquidity is a concern among investors. As units of ETF are only traded in stock exchanges, investors must wait for prospective buyers to sell their units in case they want to redeem the same. It can become a huge issue when one needs money urgently, and they are not able to find prospective buyers.
- Tracking or Monitoring Errors
ETFs, come with a lower tracking error when compared with index funds. Investors have an opportunity to track ETFs more closely. This luxury is not available in index funds.
AMCs offering index funds need to keep some percentage of cash aside for meeting redemption requests. The high liquidity of index funds leaves room for tracking errors. For example, the Sensex Index Fund follows Sensex in terms of building a portfolio. Now the fund manager may require Rs. 25,00,000 to build a portfolio that resembles the Sensex index. But he/she has only Rs. 20,00,000 to invest, so they wait for investors to pump in more money to invest in the securities.
ETF does not have to face such delays as fund managers can buy a unit whenever they are available in the markets. Hence, they track benchmarks more closely.
- SIP Availability
SIP or Systematic Investment Planning is a very popular method of investing in mutual funds. Index funds offer investors the option of investing via monthly SIPs. However, ETFs do not offer their investors the luxury of investing via SIP. SIPs are an affordable and disciplined method for wealth accumulation by small investors. So, investors going for ETFs will miss out on benefits arriving from SIP.
Things to Consider while Investing in ETF or Index Funds
There are many similarities between the two funds, so one must choose that fund that aligns with their goals. Here are some things individuals must consider before investing in either ETF or index funds:
- Investment Goals
Investors having long-term goals may prefer to go for index funds via SIP. This is a disciplined way of investment that accumulates wealth in the long term. On the other hand, individuals looking for more short-term or medium-term investment objectives may prefer ETFs.
- Risk Appetite
As ETFs trade on stock exchanges, they come with the volatility of the stock markets. Therefore risk-averse investors may not be optimistic about this investment. On the other hand, index funds are less volatile as they do not engage in active Intraday trading. It may be a good choice for risk-averse individuals.
- Expense Ratio
The expense ratio of ETFs is quite lower than index funds. However, exchange-traded funds come with some inherent costs that add up to the final expenses. Hence one must consider the explicit and implicit costs associated with these funds before going for an investment.
- Fund Manager’s Performance
Investors must go through the performance of fund managers of both these funds before investing in them. In the case of index funds, the manager simply follows the benchmark indices, so their individual performance does not matter much. However, in many ETFs, managers play an active role in creating a portfolio and selecting the stocks. Their decisions have a direct bearing on the performance of the fund.
Investors must carefully analyse the fund manager’s performance and see whether his/her policies align with their investment goals.
Also read: 15 Best Index Funds to Invest in India in 2022
Final Word
Both ETF and index funds have certain differences in their working and management. Index funds may be a good option for long-term investments, and ETFs may be tempting for investors who can strategically use them during the highs and lows of stock markets. ETF vs Index funds and which is better among them depends on the investor.
Do index funds interest you? If so, diversify your portfolio and build wealth over time with Navi Mutual Fund. You can find a wide range of low-cost mutual funds and an excellent opportunity to invest in foreign companies with Navi US Total Stock Market Fund of Fund. Happy investing!
FAQs on ETF vs Index Funds
Ans: Yes, investors willing to buy units of ETF must open a Demat account with a registered broker and start their investment. This is because ETF units are listed and traded on stock exchanges and their buying or selling happens much like shares.
Ans: Index funds are less tax-efficient than ETFs. When an investor wants to redeem his/her units in an index fund, then the manager will have to sell some securities to pay for that investor. Gains arising from such sales are distributed among investors as per their share in such securities. So, there may be a case when an individual may pay capital gains tax even without selling their shares.
Ans: ETFs, pay full dividends to their investors. These dividends are paid by companies whose stocks the ETF holds. Some fund houses pay dividends quarterly, and some pay them annually to their investors.
Ans: One can go for an index fund through SIP or a lump sum method. Investors can visit the fund house’s website or the intermediary to start investing in an index fund. They must select the mutual fund scheme and complete the KYC to start their journey of investing in index funds.
Ans: ETFs are related to a specific sector. There are ETFs related to gold available on the stock exchanges. These ETFs have the same value as that of a 24K physical gold. These ETFs constantly follow the price of pure gold in bullion markets.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
