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ETF vs Index Fund: What's the Difference?

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ETF vs Index Fund: What's the Difference?

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While most people are always curious about the differences, let’s look at the common factors first. But before we get to that, let’s take a step back and have a quick overview of both these financial funds.

Exchange-Traded Funds (ETFs) work pretty much like Mutual Funds and have a pool of equity from a large number of investors. They track indices like Nifty 50 or BSE Sensex or thematic sectors like green energy or rural development and are traded on the stock exchange. 

Index Funds are passively managed mutual funds (or even ETFs in some cases) that are built to replicate the performance of the indices they track. Passive management translates to a low involvement of the fund managers in choosing which stocks to include in the fund’s asset allocation mix.

Common Bonds - No, Not The Income Bonds

Ok, so with that recap out of the way, you would have already noticed some similarities between the two. Both these funds tend to follow a targeted index or theme-based basket of stocks. Hence, their performance is usually more predictable, which is often directly correlated to the performance of its master, so to speak. Another similarity stems from the fact that there are a vast array of ETFs and Index Funds with various underlying asset classes allowing you to diversify your portfolio. Diversification is lesson #1 in any financial literacy course, or it should be. 

By investing in different assets, you can reduce your risk and exposure and protect your portfolio from market volatility. One more common bond between these two financial instruments is that they are passively managed. Index Fund always and ETF almost always. This tends to keep their costs low, as fewer administrative and management activities are involved. Lower costs mean more returns for you. 

Then why the two different funds?

That's because there are certain distinctions as well. Let me encapsulate the main ones here before going into their specifics.

Investing or Trading Mechanism

Possibly the biggest difference between the two is that the trading mechanism of ETFs is almost exactly like that of shares. ETFs are listed on the stock exchanges, and their price keeps going up and down. They can be bought and sold on the stock market at any time in the course of the trading day at the prevalent price. 

The price of Index Funds, on the other hand, is fixed at the end of each trading day. So, if you wish to redeem your holding units, they will be paid out at a price published at the close of the day of request. Now, this will probably not make a difference for long-term users. But if you wish to indulge in intraday trading or use the stock market features such as Stop-Loss and Market Orders, these are not possible.

Since ETFs are traded on the stock market, in accordance with SEBI rules, you need a Demat Account held with some brokerage house. There is no other way to buy or sell ETFs. An Index Fund has no such requirement. By completing the mutual fund KYC process, you can purchase Index Fund units from any authorised intermediary. If you use the Fi app, you can conveniently use the same app to invest in Index Funds of your choice.

Minimum Investment - Flexibility in Investment Amounts

Another difference is the minimum sum required to invest. ETFs, like other shares, can be only bought and sold in whole units. In other words, if the price of one unit of an ETF is ₹100, then you can buy an ETF in whole multiples - for example, ten units for ₹1000. 

In Index Funds, though, you can invest your preferred amount and get corresponding units in lieu of, with a minimum being ₹500. This makes investing in Index Funds slightly more convenient as you can choose to park surplus cash - at any time and for any amount.

SIP Options

Systematic investment plans or SIPs are rightly credited for the huge surge in the popularity of mutual fund investment in India. By choosing to set aside a certain amount each month, you can significantly build long-term wealth through the power of compounding. Moreover, SIP promotes a financially healthy habit of investing regularly. In the case of most ETFs, this is not possible. Each time you wish to invest in an ETF, you will need to do it deliberately, which can be cumbersome and easy to miss.

Costs and Expenses

The costs associated with ETF trading typically include Depository Participant charges, Demat account opening, annual maintenance charges, and brokerage. While the broker predominantly levies these, there can be additional charges such as GST, exchange fees, and commission. 

While buying Index Fund units, the main cost to look out for is the Total Expense Ratio (TER). This is charged by the Asset Management Company (AMC) as a cost to manage your investment and is usually mentioned as a percentage. It is not levied upfront but is deducted at the time of redemption. So, if the TER is mentioned as 0.5%, then it implies that your final returns will be 0.5% less as a result. Fortunately, since Index Funds are largely passively managed, they come with a low TER.

So, what’s the right one for me?

Good question. This is a distinctly personal choice based on your financial goals, risk appetite and preferred investment style. 

Long-term investors are better off using Index Funds to generate wealth. Regular contributions can be made to the fund by using SIP as a disciplined investment mechanism. They are simpler to track and require lesser attention and effort. More experienced investors with a sound knowledge of market swings who would like to capitalise on market volatility (like ‘buying the dip’) will find ETF trading more suitable, as intraday or very short-term trading is not possible in Index Funds.

A newer style of investment is a hybrid of the two, wherein Index Funds are core SIP-based investments for long term goals like buying a house or a retirement fund, while ETFs are used to meet short-medium term goals like buying a car or travelling abroad. The key, as always, is to be regular, structured and disciplined in your investments. 

FAQs

  • Between ETFs and Index Funds, which provides better returns?

Studying their historical performance, both ETFs and Index Funds have provided comparable returns. This is largely due to the fact that their performance is dependent on the indices or basket of stocks they track. Therefore, it is important to check and compare the overall cost of ownership of each before choosing to invest in them. 

  • Do Index Funds have lower risks than ETFs?

Here, too, both of them are rather alike. The risk actually stems from the underlying stocks and other assets that make up the ETF or the Index Fund portfolio. Their volatility directly affects the performance and returns of your chosen form of investment. The slight advantage offered by Index Funds is that, as per SEBI laws, each fund scheme has a clearly denoted risk level. You can use this information while considering which one to invest in.

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