- ETFs vs Index Funds - Where should you invest your money in?
- Read this post that compares between the two in terms of various aspects before choosing from them.
Passive funds involve no active fund management and just mirror the benchmark. Passive investing has been trending and seeing increased interest globally, especially in the West. In the United States, passive funds’ AUM is now bigger than the active funds’ AUM, the same is the case with most of the European markets and Japan. This is because active fund managers have not been able to beat the returns from an index fund due to two factors-higher cost and efficient markets.
In India, passive investing is on the rise but nowhere near to active funds since the markets are relatively inefficient, giving the active funds an opportunity to perform better. Also, the awareness about mutual funds in general is low, that for passive investing is even lower. To invest in a passive fund, one can do so through an ETF (Exchange Traded Fund) or an Index Fund. Let us understand both.
What is an ETF?
An ETF or an exchange traded fund is a fund which is listed on the stock exchange and can be bought or sold only on the exchange. Simply put, you cannot buy or sell an index fund directly with the mutual fund after the NFO (new fund offer) of the fund closes. Once the initial launch of the fund is done, money is collected and the fund is listed on the exchange. One needs to have a demat and trading a/c to buy and sell an ETF. This is unlike any other mutual fund that can be directly bought or sold through the mutual fund company. An ETF mirrors the benchmark and holds the same portfolio. For example, a Sensex ETF will have stocks that are there in the Sensex with the same weights. To buy or sell an ETF, one needs corresponding buyers and sellers on the exchange.
What is an Index Fund?
Like an ETF, an index fund also mirrors the benchmark in terms of the portfolio. For example, an HDFC Sensex Fund will have the same portfolio in the same weightage as the Sensex. Therefore, this fund will give the same returns as the Sensex. The only difference will be that an expense ratio which is the cost of managing the fund will be deducted from the returns. An index fund could be a debt or an equity fund. Within equity funds, there are large-cap index funds, small-cap index funds etc. To know more about index funds, you can read another post of ours – WHAT ARE INDEX FUNDS–SHOULD YOU INVEST?
Comparison of ETF & Index Funds
Let us compare ETF and index funds on different parameters:
Transacting Process – This is a fundamental difference between the two- ETFs can only be bought and sold on the stock exchange whereas an index fund can be directly bought and sold through the AMC.
Demat & Trading A/C – You need to compulsorily have a demat and trading a/c to transact ETFs whereas the same is not necessary in case of an index fund.
Cost of Investing – The expense ratio or the cost of an ETF is minimal, usually around 0.05% annualized. It is lesser than an index fund, where cost is in the range of 0.10%-1.00% for different funds and plans (direct and regular), so one needs to check the same before investing. However, one will need to pay the Demat maintenance charge and brokerage for buying and selling an ETF.
Ease of Buying and Selling – ETFs in India currently are relatively difficult to buy and sell since you need to find a buyer and seller yourself on the exchange which could be tedious due to low interest for ETFs in India. Due to low awareness, there are not many who have bought ETFs, so lesser people are active on the exchange doing transactions. Buying and selling an index fund is much easier, it is as easy as buying and selling any other mutual fund scheme.
Pricing – The price of the ETF is dependent on the demand and supply for the same. So, if demand is higher, you will get a better selling price and vice versa. Index funds pricing does not vary basis demand and supply, it is a result of the movement of the stocks or bonds held by the benchmark index.
Which is Better – ETF or Index Fund?
ETFs have the advantage of lower cost over index funds. However, index funds have more advantages such as the ease of transacting, buying and selling at will and no compulsion of having a demat account. While cost is the biggest factor when investing in a passive fund but in India due to low awareness there is lesser liquidity in ETFs. Therefore, we recommend you to invest in an index fund. In the future when there is more awareness and liquidity about ETFs, one can look at them, but for now, investing in index funds is a better option.