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.
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.
- 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.
- 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.
- 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.
- 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.
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