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Index Funds vs ETFs – What is the Difference between Index Funds & ETFs

Learn about index funds vs etfs. Their advantages, disadvantages and how to use them to create wealth and get quality returns.
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Investing in an index

As an investor, if you are looking to invest in a basket of securities at a low cost, then a passive investing strategy will work for you. Within passive investing, you can choose to invest either in an index fund or an Exchange Traded Fund (ETF). Both investment products are offered by mutual funds. The index fund and an ETF, both, have an index as their underlying. They have a common objective, to track the performance of an index and match the returns of the index. Learn about index funds vs etfs in this article.

An index fund is a form of mutual fund that invests in a portfolio that is designed to mirror or match the components of a financial market index. ETFs can be traded more easily than index funds and traditional mutual funds, just like common equities on a stock exchange.

Index funds and exchange-traded funds (ETFs) may appear to be the same thing, but they are not. They're two of the most often used passive investment strategies.

What is Index Funds?

An index fund is a form of mutual fund that invests in a portfolio that is designed to mirror or match the components of a financial market index. Its asset allocation seeks to match that of the popular index it is attempting to imitate. Since index funds do not have their own cash, they invest more in liquid securities. As a result, there is a tracking mistake in index funds. The tracking error is proportionate to the difference between the returns generated by an index fund and the returns generated by its underlying index.

What is Exchange Traded Funds? 

Shares that make up major indices like the NSE Nifty 50 and the BSE Sensex make up an exchange-traded fund. If an ETF tracks a specific index, the index will be made up of the same companies as the index, with the same weighting. The ETF may also invest in money market securities for liquidity reasons. Returns on exchange-traded funds (ETFs) are generally predictable and will be close to those of the underlying index.

Despite the fact that many ETFs track the same index, their returns will vary due to variances in debt holdings. ETF units are exchanged on stock markets in the same way as shares are.

Differences between an index fund and an ETF

Some of the differences between an index fund and an ETF include:

Method of buying:

  • Index funds are open-ended schemes. Their units can be bought from the Asset Management Company (AMC). You can make a one-time purchase with a lumpsum amount or regular purchases through the systematic investment plan (SIP) mode.
  • ETFs are close-ended schemes. You can buy from the AMC at the time of the New Fund Offering (NFO). Once the NFO closes, the units are listed on the stock exchanges like the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) and traded during market hours. If you wish to buy after the NFO, then the units can be bought from a seller through the stock exchange by placing an order with a stockbroker.

Pricing:

  • For index funds, the Net Asset Value (NAV) is declared by the AMC at the end of every trading day. For SIP investors, the units are allotted at the NAV declared. Similarly, for redemption requests also, the end of trading day NAV is applicable.
  • In the case of ETFs, the price is discovered in real-time during market hours just like it happens for equity shares. The price of an ETF unit depends on the demand-supply and liquidity. Due to this, the price of an ETF unit may be at a premium or discount to the actual NAV.

Tracking error:

  • An index has to maintain some liquidity to meet the redemption requests of investors. Due to this, the index fund cannot track the performance of the underlying index perfectly. This deviation is known as a tracking error.
  • In the case of ETFs, the buying and selling happen through the exchange and the scheme has no role to play in this. Hence, ETFs don’t need to maintain liquidity to meet redemption requests. Hence, the tracking error of ETFs is lower than that of index funds.

SIP mode of investment:

  • The systematic investment planning (SIP) mode of investment is available only in the case of index funds as investors can buy units from the AMC.
  • In the case of ETFs, the SIP mode of investment is not available as the buying and selling happen through the stock exchange.

Requirement of a demat account:

  • In the case of index funds, the mutual fund house generates a folio number for the investor. The index fund scheme units are then mapped to the folio number. The investor can check his/her portfolio details in the dashboard on the AMC website. The redemption of units is also done with the AMC directly. Hence, there is no need for a demat account for investing in an index fund.
  • In the case of ETFs, a demat account is a must. The units bought from the stock exchange will go through the normal clearing process and get credited to the demat account. Similarly, when ETF units are sold to another buyer through the stock exchange, during the clearing process, the units will be debited from the demat account. The demat account opening charges, annual maintenance charges, and any other related charges increase the costs of investing through ETFs.

Minimum investment amount:

  • For investing in an index fund the minimum investment amount is decided by the AMC. The minimum amount for investing in an NFO is usually kept at Rs. 5,000 and that for a SIP is usually kept at Rs. 500.
  • For investing in an ETF, the minimum amount (usually Rs. 5,000) at the time of NFO is decided by the AMC. Thereafter, once the units are listed for trading on the stock exchange, you need to buy a minimum of 1 unit. The minimum investment amount for an ETF is equivalent to the price of 1 unit at the time of purchase.

Exit load:

  • If you wish to redeem your index fund units before a specified time duration, the AMC may levy an exit load.
  • In the case of ETFs, there is no exit load and the investor can sell the units at any time without any specified holding period.

Reinvestment of dividend:

  • While investing in an index fund, if an investor chooses the growth plan or dividend reinvestment plan, then the dividends get reinvested automatically by the AMC without any action required to be taken by the investor. Additional units equivalent to the dividend amount are allotted to the investor.
  • In the case of an ETF, whenever a dividend is declared, the amount gets credited to the investor’s bank account. This amount has to be reinvested manually by the investor.

Liquidity:

  • In the case of an index fund, liquidity is not an issue at all. The investor can redeem the units with the AMC at any time. The investor will get the net asset value (NAV) applicable at the time of redemption.
  • In the case of an ETF, the units have to be sold to another buyer through the stock exchange. Hence, in the case of an ETF, there can be a liquidity issue if the trading volumes are low.

Assets under Management (AUM):

  • In case of an index fund, the AUM increases with regular inflow of subscription money and the creation of new units. Similarly, the AUM decreases when units are redeemed and money is paid back to the investor. At the same time, the AUM also increases/decreases with a rise/fall in the value of underlying securities.
  • In the case of an ETF, the AUM increases/decreases only with the rise/fall in the value of underlying securities. In the case of an ETF, after the NFO closure, the AUM does not increase due to the inflow of subscription money as it is not allowed. Similarly, units cannot be redeemed with the AMC and hence the AUM will not decrease.

Index funds or ETFs: Which one should you choose?

The choice of an index fund or ETF depends on the needs of the investor. If your objective is to accumulate money for a long-term financial goal like retirement, then you can choose to make regular investments in an index fund through the SIP mode. You will be allotted units equivalent to the SIP amount every month. Once your goal is realised, you can redeem your money with the AMC and enjoy your golden years.

If you are bullish on a particular sector, say for example banking, in the short term, then you can buy an ETF that tracks a banking index. Also, if you want to take a short-term directional bet on the market, then you can invest in a Nifty ETF. When investing in ETFs, you need to bear in mind that liquidity can be an issue and there will be additional demat account charges.

The Glide Invest App gives you an option to invest in an index fund, depending on your requirement. Just download the app and start investing now!

FAQs

Q1: What can be said about Index Funds in India?

A1: A mutual fund that tracks the components of a market index, such as the BSE Sensex or the Nifty, is known as an index fund. It invests in equities that form up the same proportion of an index. If you want your returns to match the underlying index, index funds are a good option. It's a low-risk investment with modest management fees.

Q2: How can I invest in Index Funds in India?

A2: Index funds can be purchased directly from the AMC or through a mutual fund distributor. You can, however, invest directly with the mutual fund house by visiting a branch or visiting the mutual fund's website.

Q3: Can we say that Index funds are better than Mutual Funds?

A3: Index funds follow the performance of a market index, such as the BSE Sensex or the Nifty, and provide returns that are similar to those of the index. It is passively managed and has a lower expense ratio than actively managed funds. Fund managers of actively-managed equities funds seeking a higher return than a benchmark index may be worth considering. Index funds, on the other hand, have been demonstrated in studies to outperform actively managed equity funds over time.

Q4: What can be understood by Exchange Traded Funds?

A4: ETFs (Exchange-Traded Funds) are mutual funds that track a market index such as the BSE Sensex or the Nifty. It's a stock portfolio that mimics an index. When comparing ETFs to index funds, you can think of them as the same thing. ETFs, on the other hand, are exchanged like stocks on the stock exchange and can be traded at any time of the day. You can only buy and sell index funds at the end of the trading day's specified price.

Q5: How should I choose Index Funds?

A5: To choose Index Funds you can:

Put your money into an index fund that tracks a large section of the market, like the Nifty 100.

Look for low-tracking-error index funds. With a low tracking error, a fund closely resembles the index it tracks.

Look at the index fund's investment costs.

Consider looking at the mutual fund house's track record as well as the assets under management.

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