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:
- 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.
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.
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.
- 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.
- 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.
- 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.
- 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.
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