ETF vs Index Fund – ETFs and index funds have many similarities. Both are passive investment vehicles that combine investor funds to purchase a basket of assets that correspond to a market index. While actively managed mutual funds seek to outperform a particular benchmark index, ETFs and index mutual funds are often designed to monitor and match the performance of a market index.
However, the distinctions between an ETF (exchange-traded fund) and an index fund are not as negligible as they may initially appear. It is not only a matter of performance or which style of fund provides the highest returns.
What Are ETFs?
Exchange-traded funds (ETFs) are somewhat distinct. ETFs are comprised of underlying investment units. They are produced and redeemed in bulk. They trade on the market like equities.
This implies that the price fluctuates often throughout the trading day, and they are more adaptable than mutual funds. Dedicated applications such as Public facilitate the purchase and sale of ETFs.
ETFs, like mutual funds, may include an annual fee, known as a “expense ratio,” although the price is often fairly minimal. Additionally, there is no need to sell investments held within an ETF when an investor decides to exit. This indicates that a capital gains tax owing to fund turnover is unlikely to come as a surprise.
The principal benefits of ETFs are as follows:
- Investors can short sell or purchase on margin. As there are no minimum investment limitations, they can also acquire one share.
- When buying or selling ETFs, the commission paid to the broker is the same as when placing a conventional transaction.
- It is akin to a mutual fund that may be purchased and sold during the day at fluctuating prices. The transactions are also conducted in real time.
Who Should Purchase ETFs?
Invest in ETF if asset allocation is of greater importance to you than choosing individual equities. ETFs are more flexible than mutual funds since they may be exchanged on the exchange like equities. You often do not need to be concerned about load costs, and you may trade throughout the day. However, these investments perform best for people with a long-term investment horizon.
Where to Purchase ETFs
ETFs may be purchased virtually anywhere that allows stock trading. ETFs are offered by most traditional and internet brokers. Typically, their transaction costs are identical to those of stocks.
What are Mutual Funds?
Mutual funds are professionally managed investment funds that invest in a diverse portfolio of assets. Various investors’ funds are pooled and invested with the aid of specialists. The portfolio may consist of bonds, money market instruments, equities, or a combination of all three. The investor holds a share of the mutual funds and shares in its profits and losses.
ETF shareholders receive a portion of the gains, such as dividends and interest. They may also get a residual value if the fund is liquidated. ETF shares are often traded on public stock exchanges, so they may be readily transferred, purchased, or sold in the same manner as ordinary shares.
The supply of ETFs is governed by “creation” and “redemption” procedures involving special investors, often known as “authorised participants” (APs). APs are often well-known financial entities with considerable purchasing power, such as banks and investment corporations.
Who Should Purchase Mutual Funds?
Mutual funds are suitable for investors who need quick portfolio diversification without selecting specific stocks. You may tailor the asset allocation of a mutual fund to your risk profile. Best mutual funds in india are generally suitable for passive, long-term investments in which the investor does not plan to trade frequently.
Where Can Investors Invest in Mutual Funds?
Multiple internet brokers offer access to mutual funds. However, you may require a minimum investment amount to purchase mutual funds. Additionally, pay particular attention to the expenses connected with mutual funds, as various fees might affect your total performance.
What is the distinction between index funds and ETFs?
The most significant distinction between ETFs and index funds is that ETFs may be exchanged throughout the day like stocks, but index funds can only be purchased and sold at the conclusion of the trading day.
This problem is not a major worry for long-term investors. Buying or selling at noon or 4:00 p.m. is unlikely to affect the value of the investment twenty years from now. However, if you are interested in intraday trading, exchange-traded funds (ETFs) may be a better fit. They may be traded like stocks, yet investors can still derive diversification benefits.
1. ETF vs. Index Fund: Difference In Fund Management Style
ETFs can be passively managed or actively managed, whereas index funds are passively managed. Currently, around 20% of ETFs in the United States are actively managed. This indicates that an investing team is conducting company research and making tactical decisions on how to construct the ETF’s portfolio, which stocks to acquire, which to sell, etc.
The structure of these active ETFs may be fairly inventive. By copying the portfolios of prominent investors such as Warren Buffett or Rakesh Jhunjhunwala, for instance, it is possible to create an ETF that mimics their investment strategies. Cathie Wood’s work with the ARK Innovation ETF is an additional illustration of an innovative ETF. This ETF is only focused on “disruptive innovation,” which includes investments in DNA technology firms, industrial innovators, health technology, and next-generation Internet companies.
2. ETF vs. Index Fund: Difference In Trading Style
An index fund is a mutual fund, but an ETF more closely resembles the functioning of a stock. This is because ETFs, like stocks, may be traded throughout the day on exchanges. Consequently, the price of an ETF fluctuates throughout trading hours.
Index Funds, on the other hand, may only be purchased and sold at a price that is announced at the conclusion of each trading day. This is not a significant worry for long-term investors. However, if you are an investor seeking to timing the market, ETFs with features such as intraday trading, stop losses, order limitations, etc., might be useful.
Due to the fact that ETFs are traded on exchanges, investment in ETFs requires both a trading account and a demat account. However, purchasing an index fund might be less complicated. If you have completed your Mutual fund KYC, using the app to follow and invest in Index Funds is a handy method to invest in Index Funds.
3. Minimum Investment Difference Between ETFs and Index Funds
Typically, ETFs are purchased in units. Just as you would purchase 10 or 20 shares of a company’s stock, you must purchase 1 unit, 7 units, 100 units, etc. of an ETF. Therefore, if one unit of an ETF costs Rs. 40, you must buy in multiples of Rs.
Index Funds, on the other hand, are often purchased based on a dollar amount. Therefore, you invest 500, 1,000, or 2,000 rupees in an Index Fund.
This unit vs amount context influences the minimum investment required to purchase any of these financial instruments. Similar to ETFs, the majority of trading platforms enable investors to purchase a single unit. A single unit of the ICICI Prudential Bharat 22 ETF, for example, might cost around Rs. 40. Therefore, you can get one unit of ICICI Prudential Bharat 22 ETF for merely Rs. 40.
However, when purchasing units in an Index Fund, all mutual fund providers demand a minimum order amount of at least Rs. 100, with some AMCs requiring a minimum order value of Rs.
4. ETF vs. Index Fund: Difference In Expense Ratio
ETFs and Index Funds have lower expense ratios than actively managed mutual funds, which is the cost charged by mutual fund firms to handle your money. However, when comparing ETFs with Index Funds, ETFs are typically less expensive than Index Funds.
For instance, the cost ratio for the HDFC NIFTY 50 ETF is merely 0.05%, but the Index Fund counterpart, i.e. the HDFC NIFTY 50 Index Plan, has a direct expense ratio of 0.20%. That’s an additional 0.15 percent, or if you want, a 300 percent premium over ETF prices.
Nonetheless, investors in ETFs should be mindful of two extra expenses. The first of these additional expenses are your broker’s commissions, i.e. the trading platform. Typically, the broker’s compensation is a percentage of the amount transacted or a flat fee per transaction. This commission or charge is typically comprised of a variety of expenditures, such as commission, GST, STT, stamp duty, exchange fees, SEBI turnover tax, etc.
The second cost associated with trading ETFs is the bid-ask spread, which is a modest transaction fee contained in the ETF’s price.
Before determining the total cost of ETFs and comparing it to the expense ratio of Index Funds, you must thus take into account the aforementioned expenditures.
5. ETF vs. Index Fund: Difference In Liquidity
When you invest in an Index Fund, the mutual fund firm adds your investment to its AUM and subsequently purchases assets in accordance with the benchmark. And because the exact reverse occurs when you desire to redeem Index Funds, there is no actual risk over liquidity.
However, when it comes to exchange-traded funds (ETFs), the lack of liquidity might be a significant worry. Unlike an Index Fund, purchasing an ETF is comparable to purchasing any other stock share. Suppose you wish to sell 100 units of your ETF, but there are no purchasers for those shares. In such a scenario, you are trapped since you will be unable to sell any of your ETF units at the price you choose; this is the liquidity issue with ETFs.
In spite of this, the liquidity situation for several ETFs in India is unquestionably improving. However, liquidity is an issue, particularly for sectoral and smart beta ETFs with very modest trading volumes.
6. ETF vs. Index Fund: Difference In Tracking Error
Exchange Traded Funds are more likely than Index Funds to have a smaller tracking error, allowing them to track an index more precisely. This is because index funds often maintain cash on hand at all times to fulfill redemption requests. In the case of ETFs, a manager of assets is not subject to this responsibility.
As previously established, ETFs are traded similarly to stocks, with sellers selling if a buyer is available. The AMC has no participation in this situation. Thus, the liquidity provided by Index Funds is the cause of a slightly greater tracking inaccuracy.
In addition, when tiny sums of money are invested in index funds, their deployment takes time. This also causes Index Funds to hoard cash. For instance, consider an NIFTY 50 Index Fund. The Index is comprised of 50 equities with varying weights. Therefore, the fund manager of an Index Fund must invest all daily cash in proportion to the index.
Assume now that the fund manager requires Rs. 15 lakh to purchase all 50 NIFTY 50 equities in the same proportion as the index. On a given day, though, the fund received Rs. 10 lakh. Therefore, the fund manager must now wait for an additional Rs. 5 lakh to purchase all 50 NIFTY 50 equities in the same proportion as the index.
ETFs confront no such difficulty. When investing with ETFs, you get units that are freely available on the market. Therefore, the asset management business does not need to keep your cash or wait until it has sufficient funds to purchase equities in the same proportion as the index.
7. ETF vs. Index Fund: SIP Availability Difference
Systematic investment plans, or SIPs, are a popular way of investment for regular investors, with monthly inflows routinely above Rs. 8,000 crore over the past several months. While Index Funds typically provide the SIP option, ETFs typically do not.
Therefore, the absence of the SIP route in ETFs is a significant disadvantage, as the SIP route continues to be a highly disciplined and consistent method for investors to engage in the stock markets. Consequently, if you are one of those investors who is more comfortable investing in equities via SIP, then index funds may be the way to go at this time.
Comparative Features of ETFs vs Mutual Funds
Diverse Exposure to Securities
The primary similarity between mutual funds and ETFs is that both provide exposure to a number of assets through a single transaction or ownership share. By investing in a bond mutual fund or bond ETF, you obtain exposure to dozens or even hundreds of bonds through a single investment instrument.
Both Rates of Charge Expense
ETFs and mutual funds are both subject to fee ratios. The expense ratio will be stated as an annual percentage.
Indexing is Available for Both Investment Types.
It is also feasible to utilize indexing for both sorts of assets. Index funds and index ETFs exist. This allows you to focus your investment strategy on a certain index, whether you utilize mutual funds or ETFs.
Which Is Better for You: ETFs or Index Funds?
ETFs and Index Funds are quite comparable. Therefore, selecting one over the other will depend on your investment objectives and investment style.
For example, if you are a long-term investor with long-term objectives, you would choose a disciplined investment strategy. This is best offered by an index fund utilizing the SIP feature. However, if you are interested in trading during turbulent market conditions, ETFs may be the more valuable instrument.
A handful of tactical investors with an above-average grasp of the stock markets frequently trade ETFs for extremely brief periods of time, particularly when there has been a news-driven market decline. In most circumstances, these 3 percent adjustments are transient, but that does not stop people from attempting to take advantage of them.
In fact, there have been 93 times in the past 15 years when the NIFTY 50 completed a session with a loss of more than 3%, and one can imagine traders and gamblers scrambling to buy and sell accordingly.
Overall, picking between an Index Fund and an ETF boils down to selecting the proper tool for the task. ETFs provide reduced expense ratios and greater flexibility, whilst Index Funds simplify the investor’s trading selections.
Index funds should be your primary holdings. This indicates that your long-term wealth-building focus should be on Index Funds, while ETFs can be utilized more strategically during news-related spikes and troughs.
Conclusion
Choosing between an ETF and an index fund isn’t as crucial as the decision to invest for your long-term goals using a passive approach. Whether you go for an ETF or Index mutual fund, you’ll enjoy lower fees, diversification, and a history of strong performance in index-based investing. Your choice aligns with the principles that can lead to successful long-term investment outcomes.
When considering such decisions, consulting with a trusted financial advisor or the best Indian stock market advisors can provide valuable insights tailored to your specific financial goals and risk tolerance.