ETF vs index funds

Not confident about creating your own equity portfolio? Indexing could provide a workaround with the help of exchange-traded funds (ETFs) and index funds. Both types of financial instruments mirror a specific stock market index. This could include benchmark indices like Nifty and Sensex, or some other index that follows a specific group of stocks. The advantages of investing in index funds or an ETF scheme are twofold: (1) your returns are in line with those of the index and (2) the likelihood of manager risk (common in case of actively managed mutual funds) is minimised.

What are index funds?

These are mutual fund schemes in which the fund manager creates an asset portfolio that replicates the chosen index. So, fund managers of index funds do not have to think about stock selection. They must simply minimise the tracking error—that is, the extent to which the fund does not mirror the index.

What are ETFs?

An ETF represents a basket of selected assets which mirror a specific index. All ETFs are listed on the stock exchange and traded just like stocks.

Difference between index funds and ETF schemes

  • Transaction: Since index funds are mutual funds, you can buy units by paying a lump sum or through a systematic investment plan (SIP). ETFs trade like securities on the stock exchange.

  • Expenses: The total expense ratio (TER) of any mutual fund is disclosed on the fund’s website. It includes management fees, custody fee, registrar charges, operating charges, and other such costs. However, assessing the costs associated with ETFs is a little more complex. Here, one must factor in transaction charges, holding fees, brokerage, and other costs of owning and holding securities.

  • Pricing: The market price of an ETF changes throughout the day based on how it is traded. But in index funds, the net asset value (NAV) is determined only at the end of the day. So, regardless of how the underlying stocks have performed, when you buy or redeem units, you do so at the day’s NAV.
  • Requirements: To invest in ETFs, you will need to open a demat and a trading account with a registered depository participant (DP) like Kotak Securities. In case of an index fund, you can directly approach the company that issues the mutual fund.
  • Ease of trading: ETF volumes are not large, which makes these securities harder to buy or sell on the stock exchange if you are an individual investor. But buying and redeeming index fund units is easier, as all such requests are handled by the fund manager.
  • Risk factor: Intraday traders may be well-placed to take advantage of a positive movement in ETF prices. Conservative investors, however, should stick with index funds, as they are stable and cannot be short-sold.

  • Stock orders: One could issue a limit order when trading ETFs. Such an order permits you to choose a suitable price at which to buy or sell the ETF. If the price is not reached, the order is not executed. Such flexibility is unavailable in case of index funds.

ETF or index fund: Which to choose?

While index funds provide low-risk returns, investors who have an appetite for risk could aim for higher returns by trading ETFs. Before choosing either instrument, however, examine the expense ratio. Also, study the historical returns to see how closely the ETF or index fund has followed its chosen index. In general, you could use index funds for stable returns and include ETFs to diversify your portfolio.