ETFs Vs Index Funds: Which One Should You Opt For?

Choice, not chance, determines your destiny

Aristotle

In investment, your choice of investing instruments determines your ability to create wealth over the long term because every small factor counts. Therefore, you should be well-informed about the investment basics, or it will impact your portfolio significantly.

For instance, the difference between the expense ratio of a regular and a direct mutual fund may look small, but over the long term, that slight difference will compound to help generate higher returns. This blog will discuss the two popular investment tools, Exchange Traded Funds (ETFs) and Index Funds. And, as a small investor, which one should you opt for?

So, let’s dive deeper.

What are ETFs and Index Funds?

People often find it challenging to understand the difference between ETFs and Index Funds because of the similar product construct. So, the primary difference between both is the style of fund management or how they are created. 

ETF and Index Funds are pooled investment securities replicating and tracking an index like the Nifty 50 or Sensex. However, these investments are not restricted to a particular index but can also invest in various themes like PSU stocks, IT and Healthcare stocks, Gold, etc.

Now, let’s understand how each unit of these funds is created.

Index Funds

When one invests in an index fund, the fund house just buys the stocks in line with the benchmark index and creates a unit. There is no restriction on the fund house on the maximum number of units that can be created, as a fund house can make or cancel units based on investors’ buying and redemption requests.

Exchange Traded Funds

The creation and redemption of Exchange Traded Fund units are a bit complex and very different from the creation of index fund units. In the creation of ETF units, two parties are involved- an ETF issuer, which can be a fund house, and an Authorized Participant (AP). An AP can be a market maker or a large financial institution.

So, whenever an Exchange Traded Fund is planned, the issuer joins with an AP. The job of an AP is to go to the market and buy the securities the ETF has to hold and deliver to the issuer. For instance, if the ETF tracks BSE Sensex, AP will buy all 30 shares in the index in the same weightage as of index and deliver them to the ETF issuer.

The issuer, in return, issues Exchange Traded Fund shares to the AP that can be sold in the open market. This is the process of creating Exchange Traded Funds shares. And in the redemption mechanism, AP buys the ETF shares from the market and returns them to the issuer. In exchange, the issuer releases the exact value of underlying securities to AP.

Difference Between Exchange Traded and Index Funds

If both mimic any particular index, what are the differences between Exchange Traded Funds and Index Funds? Many investors have this question. So, we will uncover it in this section.

The difference in trading style: Since index fund units are treated as mutual funds, they can be bought and sold at a price published at the end of the day. Exchange Traded Funds are listed on stock exchanges and can be traded like any other stock during trading hours. So, you can consider day trades and place stop-loss orders with ETF shares.

Expense ratio: Both the Exchange Traded and Index Funds are subject to management fees and are reported as the expense ratio. Compared to index funds, ETFs have a lower expense ratio as no frequent unit creation or redemption is required. Only a finite number of ETF shares in the market are traded.

For example, SBI Nifty 50 ETF has an expense ratio of 0.07%, whereas SBI Nifty Index Fund (Direct) has an expense ratio of 0.18%, over 150% higher.

Tracking error: It is the divergence between the actual return of an index and an index fund or Exchange Traded Fund. It happens primarily due to the trading costs of stocks and improperly replicating the index.

As index fund managers have to keep a part of the fund in cash or cash equivalent to honor the redemption request, the tracking error is slightly higher than Exchange Traded Funds. However, there are no such constraints for ETFs as they are directly traded in the market, resulting in a lower tracking error.

The difference in investing: You can invest through SIP or lump sum with index funds. However, you must invest the minimum amount if you are not investing through the SIP mode.

In Exchange Traded Funds, you cannot invest through SIP mode and must directly purchase ETF shares from the stock exchange through your trading account.

Exchange Traded Funds vs. Index Funds: What Should You Opt?

Now that you know the difference between Exchange Traded and Index funds, which one should you choose?

Both cater to the needs of different sets of investors. For instance, index funds are a good option for long-term investors as it allows for a disciplined investing approach. On the other hand, such funds are suitable for beginners and those who fear trading in stocks due to price volatility.

Whereas Exchange Traded Funds are suitable for investors with a good understanding of the stock market and who want to profit from the price volatility in the short term. For example, you can buy Exchange Traded Fund shares if you’re going to benefit from the news-driven market rally or dip while avoiding stocks. Also, you can consider these funds for long-term investing as it offers better unit economics and flexibility.

The choice between index funds and ETFs should be based on your investment objective. For example, if you focus on wealth creation over the long term, you must select index funds, while ETFs offer better trading opportunities.

FAQs

Read more:  How Long-term investing helps create life-changing wealth – TOI.