Choosing between Index ETFs and Index Funds

You made a passive choice; now what?

Today a lot of investor are preferring passive investing or index based investing. After all, they are cheaper in terms of costs. Also, most fund managers are anyways struggling to beat the market, so as well stick to the market. This way, investor 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, unlikely 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 will be 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 index ETF. Both looks 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. But first the pros and cons of index funds versus index ETFs.

Table of Contents

1. You made a passive choice; now what?
2. How to make a choice between Index Funds and Index ETFs?

How exactly do Index Funds and Index ETFs compare?

Remember, that both the index fund and the index ETF will essentially mirror an index. This index could be the Nifty, Sensex, Bank Nifty, IT index or any other index that is agreed upon. The basic idea in an index ETF and an index fund is that they will only try to mirror the index and give returns that are closely aligned to the index returns. There will be no alpha hunting.

Let us first understand what is an index fund. It is like any other regular equity mutual fund scheme. The fund manager, instead of selecting stocks and trying to create alpha for the investors, will purely focus 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 that the fund manager has to do, so they do not need an army of analysts, traders, and fund managers. That can reduce costs. The only effort the fund manager puts in here is to ensure that the tracking error is kept at bare minimum. Just for understanding, the tracking error reflects the extent to which the index does not mirror the index. This can be a positive or negative divergence and the passive fund evaluating the tracking error looks down upon any kind of deviation. The focus is to keep the tracking error as low as possible. 

So, what is an index ETF? An Index ETF can be understood as fractional shares of the index. An exchanged 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 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 1/10^th unit of Nifty will be quoting in the market around the absolute value of 1,945. There will obviously be some divergence due to costs and taxes. 

How to make a choice between Index Funds and Index ETFs?

There are 5 rules that you can basically follow to make a choice between index funds and index ETFs.

1. 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. The net effect each day will either increase or decrease the AUM. That is not the case with index ETFs. As long as there is liquidity and there is a counterparty, you can keep buying or selling units and the overall AUM will not be impacted in any way.
   
    
2. When you buy fresh index funds or redeem such index funds, the deal will be executed at the end-of-day (EOD) NAV. The NAV is the net asset value based on market value of all holdings adjusted for the total expense ratio (TER) on a daily basis. In the case of ETFs, being an exchange trade product, all prices are real time, and there is no EOD NAV concept at all. Only prices are set based on NAV, but no NAV takes place at the NAV.
   
    
3. The big advantage for ETF is that the Expense ratio in an Index ETF is much lower than an index fund. In India index funds have an expense ratio of 1% to 1.25% while index ETFs have an expense ratio of about 0.35% to 0.45%. That is the TER that is debited to the index ETF. In addition, when you buy and sell the index ETF you are also liable to pay the brokerage and other statutory costs, so factor that in too.
   
    
4. Index funds have an edge over index ETFs in that you can structure a systematic investment plan (SIP) in an index fund. Today, if you look at the SIP AUM, it has become a preferred product. However, SIPs are not possible in index ETFs. Remember, index ETFs are closed ended products and so the benefit of automated SIPs are not available in an index ETF. This is an area where index funds score.
   
    
5. Since ETFs are traded on the stock exchanges like other stocks, the dividends are directly credited to your registered bank account linked to your demat account. This is a hassle from a financial planning point of view as the dividends have to be manually reinvested. In case of index funds, you can opt for a growth plan where dividends are automatically reinvested.

Both index funds and index ETFs have their pros and cons. You can use your judgement to make the best choice.