ETFs VS Index Fund: Where Should Investor Invest?

ETFs and index Funds are two of the popular forms of passive investing. ETFs can also be actively managed, but for the sake of comparison, we will only consider passive investments. The advantage of passive investing is the simplicity it offers, such that you do not have to choose from the plethora of investment options. These simply mirror the holdings/ weightage of an index or an exchange. This article will give you an insight into how do these two differ in terms of expense ratio, flexibility, or liquidity and where should investor invest?

An index fund is a passive mutual fund that aims to achieve capital appreciation by imitating or replicating an index, such as the Sensex or Nifty. The objective of an index fund or an index ETF is to passively replicate or mirror the index in terms of its portfolio composition.

For instance, if the S&P BSE SENSEX contains 11% of HDFC shares then the index fund will also contain the same proportion of HDFC shares.

ETFs (Exchange Traded Funds) comprise shares that follow an index such as NSE Nifty 50 or BSE Sensex. As the name suggests, ETFs can be bought and sold on the stock exchanges. There are some new generation index ETFs based on popular sectors such as S&P BSE Auto, or FMCG, banking and healthcare.

Let’s understand the parameters where ETF and index fund differs:

  1. Timing the Market

Investing in ETFs can be an advantage if you can take the opportunity of the price movements that occur during the day based on your analysis of the market or the index.

In contrast, Index funds are suitable to those who do not require extensive tracking and anticipate performance that is in line with the market returns.

  1. Flexibility

ETFs are considered more flexible than most index funds.

ETFs can be traded on exchanges intra-day, like common stocks. You can buy ETFs at your convenience.

You can buy Mutual funds units by placing a request with the fund house either online or through RIA or through a distributor.

  1. Liquidity

You can trade ETFs more easily than index funds as they can be redeemed or sold anytime during market hours. Their market price is available in real-time just like common stocks.

An index fund, on the other hand, can be redeemed only at the end of the day’s NAV (Net Asset Value). NAV indicates the price per unit of a mutual fund.

  1. Ease of investing

Index funds are a good option for a first-time investor or if you are looking for ease of investing because you do not need to research.

Index Funds also offer you the option of investing through an SIP (systematic investment plan). This gives the added benefit of compounding your mutual fund returns with time and rupee-cost averaging which allows you to average out your cost of investment. They also offer the benefit of STPs (Systematic Transfer Plan) or SWPs (Systematic Withdrawal Plan).

However, index funds come with a tracking error. Index Funds tracking error indicates how much the fund performance has deviated from the benchmark index. Tracking error occurs in both scenarios; i.e. outperforming the index and underperforming the index.

Since ETFs trade like a stock, you can easily refer to the price change using the ticker symbol and compare it with the benchmark or commodity.

  1. Professional Fund Management

A fund manager of an index fund keeps track of any changes in the weightage of stocks. He /she creates a portfolio that mirrors the index performance as closely as possible. Tracking error occurs in both scenarios; i.e. outperforming the index and underperforming the index.

Since ETFs track an index or a commodity, it does not need professional fund management.

  1. Expense Ratio & other charges

If you are investing in an ETF, you may need to incur the DEMAT account’s annual maintenance charges and transaction charges with a marginal expense ratio.

Index funds come with a relatively higher expense ratio and exit loads in case you withdraw the mutual fund units before a particular timeframe.

  1. DEMAT Account

IF you want to invest in ETFs, you need a DEMAT account. However, when investing in index mutual funds, you need not have a DEMAT Account.

Choosing between index funds and ETFs depends on your preferred investing style, goal and risk profile. ETFs may offer relatively lower expense ratios and greater flexibility, while index funds simplify the decisions an investor has to make. On the other hand, if you are trying to take advantage of the opportunities of the market movements, you can consider investing in ETFs.

Not every ETF/ index fund may be suited to your goals. When investing in sector-specific funds, you need to take into consideration that these funds address a limited universe.

As an investor, you might choose to invest in an index mutual fund and add ETFs that invest in assets or sectors to diversify your mutual fund portfolio. Both index funds and ETFs are good for long-term investing.

Disclaimer: The views expressed here in this Article / Video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The Article / Video has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of the Article / Video should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. None of the Quantum Advisors, Quantum AMC, Quantum Trustee or Quantum Mutual Fund, their Affiliates or Representative shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary losses or damages including lost profits arising in any way on account of any action taken basis the data / information / views provided in the Article / video.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

@Quantum_AMC Ajit Dayal doesn’t believe in Index Funds. Watch a recent interview where he mentioned that even Jack Bongle had told him that he won’t invest in Index Funds in India. I have emailed him if he can share the email transcript or tell us more about why he said what he said. Awaiting reply.

Watch 21 minutes 53 seconds onwards.

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I received a response from Ajit.

image

I googled to find the Youtube link he mentioned in his email.

Watch from 56:25 to 1:00:06.

Again, he is saying that the way Index funds are constructed in India is very different compared to a Vanguard Index Fund is the US. And that’s why he won’t invest in Index fund in India.

@nithin Can you please share your thoughts on this difference between India and US index funds? I am tagging you because I have read a few articles which say Zerodha is keen on becoming the Vanguard of India.

Also, In another thread, I had asked you if the Zerodha AMC would be held by the units of the funds as how the Vanguard structure is, that I read. So in short the AMC company Vanguard is owned by its funds. Is that what Ajit is talking about or there is more to it?

Apart from Ajit, the other person whom I read is against Index funds is Michael Burry who considers index funds a bubble like subprime CDOs.

Hi @rupeshmandal, still early days. A lot of moving parts, we will share more once we have clarity and are ready to make a public announcement.

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@nithin Both you and Ajit gave me a cryptic response. :sweat_smile:

Regarding emailing Ajit to dig deep to find out why he said what he said about the Index funds is because I have watched his many interviews, read his articles, and something that caught my attention is -

  1. how he said that sovereign gold bonds are not diversification in the true sense because there is no underlying physical gold and govt is the guarantor, which defeats the purpose of gold as a hedge. If you go by the book of investment. In his words, you don’t take fire insurance from the same person who may cause a fire.

  2. He is swimming against the stream. The black sheep. Quantum Long Term Equity Fund never had Reliance in the portfolio. The largest market cap company in India is not in his portfolio. Not even during the 2020 bull run, when Reliance was in media so much for the foreign investments. Upon asking, why no Reliance, he had said that he has doubts about the corporate governance of the company and many issues with how it works and the true intentions of the company towards the shareholders. He had said it during a zoom session, but the AMC when it published the video on youtube, edited out that portion because of compliance. Even there I had emailed him why was the video edited out. Waited for two months to get a reply. He had explained to me that the AMC took the call for compliance. I have not heard of any other fund or AMC rejecting Reliance to have in its portfolio while others were latching onto it. That’s why I was intrigued by his words, finding him different from the crowd, and wanted to listen to his issue with the index fund, the way it is constructed. But if you watch his videos above, there was no definite answer here.

I asked you too if you can help decipher the construct of index funds in US vs India and what could be the reason for him keeping it one arm distance (apart from AMC would earn less TER) but you too left me guessing. :innocent:

AMCs always downgrade index funds where they get minimum expense ratio. And fundamentally both etfs and funds are having same underlyings. Based on individual preference(charactertics from OP) one can choose between ETF or funds.

Cryptic because I am still not sure myself. :slight_smile:

Found a video from December 2020 where Ajit read the content of his email to John Bogle dated Feb 2010 and the response he had received. https://bit.ly/2Thf2Hi

Ajit says he believes in passive investing but mentions the following drawbacks of index funds in India in their current shape and form:-

  1. High churn of an India index (compared to US indices) => adding to cost of churn for index fund mirroring the index, leading to tracking error.

  2. Index is backward-looking i.e. picking yesterday’s winners.

  3. Standard Deviation is not risk. Index ignores the corporate governance risks. E.g. Index could not avoid Satyam, Yes bank .etc.

  4. An active fund can exit a bad stock quickly compared to an index fund.

A snapshot of the content of the email that was exchanged between Ajit and John Bogle.


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