How to Choose Between Index ETF and an Index Fund

With fund managers the world over finding it tough to beat the indices, passive investing is taking off in a big way. Unlike an active fund, where fund managers try to select stocks that can outperform, passive investing is just about buying an index like the Nifty or Sensex. The passive fund does not try to beat the index returns but mirrors the index returns. That is not a bad idea, since the Sensex has given annualized returns of over 16.5% over the last 42 years, excluding dividends. Broadly, passive investing can be done through index funds or index ETFs (exchange traded funds).

Index fund versus an Index ETF

Both index funds and index ETFs essentially try to mirror an index. Let us look at the index fund first. It is like any normal mutual fund, but the fund manager does not look for alpha (outperformance). Instead, they just create an index based portfolio that mirrors the index. The job of the fund manager here is to ensure that the tracking error (variation from index) is as low as possible. Index funds can be bought and redeemed through the AMC like any other open-ended mutual fund scheme.

Index ETFs are  fractional shares of the index which are close-ended, and therefore, listed on the NSE/BSE. At the back-end, the ETF portfolio also mirrors the index. However, ETFs can be bought and sold like listed stocks at real time prices using your existing trading account. Such index ETFs can be held in the regular demat account along with other shares and securities. ETFs are much lower in cost and available on tap.

Comparing index funds and index ETFs

An index ETF and an index fund can be compared on the following parameters.

1. When you buy index fund from an AMC it adds to the AUM of the Fund and when you redeem units, AUM reduces. However, index ETFs are close-ended. The purchases and sales are just transactions between investors and does not impact the AUM in any way.
2. Index fund purchase or redemption is executed at end-of-day (EOD) NAV; which is the market value of all securities adjusted for the total expense ratio (TER) on daily basis. Index ETF prices are real time; based on the index movements during the day.
3. Index ETFs score due to lower total expense ratio (TER). Typically, an index fund has an expense ratio in the range of 1% to 1.25%. On the other hand, index ETFs have costs ranging from 0.40% to 0.60%. This can go a long way in enhancing ROI on the investment for the unit holders. However, index ETFs have other costs like brokerage plus statutory costs like GST, STT, stamp duty, exchange fees, SEBI turnover tax etc.
4. Index funds are more amenable to systematic investment plans (SIP), while index ETFs are not. These SIPs give the added benefit of rupee-cost averaging which lowers the average cost of owning units. Index ETFs being closed-ended; automated SIPs are not feasible to structure.
5. In India, index funds are available in growth plans and in dividend plans (IDCW plans). Also, index funds can be part of a regular plan or a direct plan, depending on the marketing costs you want to incur. The index ETF is normally a growth plan tracking the Total Returns Index (TRI) of Nifty or Sensex.

Both index funds and index ETFs are good ways to invest passively in the stock markets, with minimal alpha risks.