Index Funds and ETFs : Which one to Choose?

Passively managed funds are have become popular lately especially last year with them giving more returns than actively managed funds. With last year being very volatile the actively managed funds failed to deliver good returns. But on the other hand, passively managed funds have performed slightly better. Hence, it is important to have a couple of passive funds in the portfolio. But passive funds come in two variants. Index funds and Exchange Traded Funds (ETF). Investors have to choose between index funds or ETFs. In this article, we talk about each of the passive funds and which one to choose.

Index Funds

Index funds are a replica of the index like Sensex or Nifty. The weights of the securities match that of the index. The portfolio turnover for index funds is low as their portfolio only changes when the index changes. Expenses of index funds are lower than that of actively managed funds. The risk and return of the index funds are matched with that of the market as they are strongly based on a theory that the market outperforms any investment in the long term.

The only cost in an index fund is the expense ratio which is usually higher than ETFs. The fund house operating an index fund assures liquidity to the investors and the settlement happens in one day. The investors can buy or sell the units of index funds at a stated NAV whenever they wish to. Investing in index funds can be done through a lump sum or SIP.

Exchange Traded Funds (ETFs)

ETFs are also made of stocks which constitute the index of a particular exchange. The weights of the stocks in the portfolio match the weights of the stocks on the index. ETFs are bought and sold on an exchange and hence requires a demat account for transacting. One unit of ETF can be bought and sold just like how shares are traded on an exchange.

The charges of ETFs are the demat maintenance charges and transaction costs. The overall expense ratio for ETFs is low. The settlement time for ETF is 3 days hence there no immediate liquidity. The price of one unit of ETF is decided by the demand and supply of that ETF. They trade just like shares hence are highly vulnerable to market ups and downs. Investing in ETFs can be done through a demat account by purchasing just one unit.

Differences between Index Funds and ETFs

The only similarity between Index funds and ETFs is that their portfolio is mirroring an index. Even though both are passively managed the similarity ends there. Here are the major differences between the two passive fund variants.

ParticularsETFsIndex Funds
StructureThese are funds that track that an index like Sensex and Nifty.These are funds that replicate the performance of a benchmark index.
PricingETFs are priced based on demand and supply of securities.Index funds are priced as per the Net Asset Value (NAV) of the underlying asset.
ExpensesThe expenses ETFs have are trading fees and demat account fees.The expenses of Index funds are higher than ETFs as they have management fees and exit loads.
InvestmentThere is no minimum investment for ETFs. One can purchase a single unit too.One can invest in Index funds through a lumpsum investment of minimum Rs 5,000 or an SIP of Rs 500.
LiquidityETFs are slightly less liquid than index funds even though they trade on an exchange. This is because of their less popularity in the Indian market.They are liquid than ETFs and can be bought and sold anytime of the day and not just trading hours.
Settlement TimeIt takes 3 days for ETFs to settle.It takes 1 day for settlement.
TransactingOne can buy ETFs only through demat account.One can buy index funds directly from the AMC, or a distributor or any online platforms.
TaxationETFs have less tax liability than index funds. They are traded between a person and stock exchange and less possibility for capital gains.Index funds have high tax liability. They are traded between the person and fund manager. The fund manager has to sell assets to meet the redemption needs leading to capital gains and losses.

Conclusion

Both ETFs and index funds serve the purpose of diversification. Investors looking for passive funds can consider both. But what to select depends on the investor himself. The amount of investment and risk appetite highly impact this decision. The maturity, liquidity, income of the investor and preference of asset class are some of the factors that also affect the choice.

A retail investor can find index funds comfortable as they are cheap and easy to understand and less prone to market demand and supply. An institutional investor can find ETFs as a better option as they are less costly, offer tax benefits and are traded similar to stocks.

A person with high-risk appetite and who wishes for real-time pricing flexibility can opt for ETFs. A conservative investor may find index funds better. A person looking for lower cost of investment can choose ETFs but SIP isn’t available there. One has to motivate themselves to invest regularly. For regular automated investments (SIPs) index funds are a better option.

While ETFs are less costly index funds are more liquid. So it totally depends on the investor as to what to pick based on his income, risk appetite, and liquidity requirements.

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