Difference Between ETF and Index Fund

Today a lot of investors are preferring passive investing or index-based investing. After all, they are cheaper in terms of costs. Also, most fund managers are struggling to beat the market, so it makes sense to stick to the market. This way, investors neither have to worry about the portfolio mix nor about finding the right fund from a massive choice basket.

Passive investing in the most basic sense is about putting your money in equity mutual funds. However, unlike active equity investing, your fund manager does not take a call on what to buy and what to sell. The focus of the fund manager is just to ensure that the passive fund mirrors the index as closely as possible.

That brings us to the second complexity. Yes, you have a problem of choice not only in active funds, but also in passive funds. For instance, you can choose between an index fund and an index ETF. Both look so similar, so which should you opt for? The purpose of passive investing is to mirror the index and not to beat the index. So, an important decision for the investor is to choose between an index fund and an index ETF (Exchange-Traded Fund). Here is how you can go about making a choice between an index fund and an index ETF.

What is an ETF (Exchange-Traded Fund)?

An Index ETF can be understood as 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. However, once the portfolio is created the fund does not accept fresh applications or redemption requests.

You can get entry and exit into index ETFs through the stock exchange mechanism since all ETFs are mandatorily listed. They trade just like stocks, so if you have a demat account for ETF investment and a trading account, you can buy index ETFs in the market like any other stock during trading hours.

Let us also understand what is meant by fractional units. For instance, if the Nifty is quoting at 19,450, then an ETF which represents 1/10th unit of Nifty will be quoting in the market around 1,945. There will obviously be some divergence due to costs and taxes.

ETF Meaning with Example: Suppose you buy a Nifty 50 ETF. If Nifty goes up by 1%, your ETF value will also rise close to 1%, minus costs.

Table of Contents

1. What is an ETF (Exchange-Traded Fund)?
2. What is an Index Fund?
3. Key Differences Between ETF and Index Fund
4. Which is Better – ETF or Index Fund?

What is an Index Fund?

An index fund is like any other regular equity mutual fund scheme. The fund manager, instead of selecting stocks and trying to create alpha for the investors, focuses on creating a portfolio that replicates an index. This index could be the Nifty, Sensex, Bankex or even the IT index.

There is no stock selection in the index fund, so costs are lower. The only effort the fund manager puts in here is to ensure that the tracking error is kept to a bare minimum. Tracking error reflects the extent to which the fund does not mirror the index. The focus is to keep this error as low as possible.

Key Differences Between ETF and Index Fund

• Liquidity and Trading: 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. That is not the case with index ETFs. As long as there is liquidity and a counterparty, you can keep buying or selling units without impacting AUM.
   
• Pricing: Index funds are bought or redeemed at the end-of-day (EOD) NAV. ETFs are traded in real time during market hours, so there is no EOD NAV concept for trading purposes.
   
• Expense Ratio: The big advantage for ETFs is their lower expense ratio. In India, index funds have an expense ratio of 1% to 1.25%, while index ETFs have about 0.35% to 0.45%. However, ETFs also incur brokerage and statutory costs when buying or selling.
   
• SIP Availability: Index funds allow systematic investment plans (SIPs), which are not possible in ETFs. This is a big plus for investors who prefer disciplined investing.
   
• Dividends: In ETFs, dividends are credited directly to your bank account linked to your demat account and must be manually reinvested. In index funds, you can opt for a growth plan where dividends are automatically reinvested.

Which is Better – ETF or Index Fund?

When comparing Index Fund vs ETF for beginners, both mirror an index like Nifty, Sensex, or Bank Nifty and aim to match index returns without alpha hunting.

• ETF vs Mutual Fund Difference: ETFs trade like stocks on an exchange, while index funds are bought and sold through the fund house at NAV.
   
• ETF vs Index Fund Returns: Returns are typically similar, but ETFs may slightly outperform due to lower expense ratios, provided liquidity is good.
   
• Demat Account for ETF Investment: Required for ETFs, not for index funds.
   

Both index funds and index ETFs have their pros and cons. Investors can use their judgment based on liquidity preference, cost, SIP need, and convenience to make the right choice.