Index Fund vs ETF – Which One Should You Prefer?

Passive investing is gaining traction in India, especially after investors have witnessed several active mutual fund schemes not consistently beat the index. Two common ways of passive investing are a) Index funds and b) Exchange Traded Funds (ETF). Investors generally get confused about the right investment option for them, given the lack of proper knowledge. This article compares Index funds and ETFs on various parameters so that you can evaluate and make the right decision appropriate to your financial situation.

This parameter makes for the most robust case for ETFs compared to index funds. ETF has a much lower expense ratio as compared to an index fund. For example, suppose an index fund has an expense ratio of around 0.10% to 1%. In that case, you may find the ETF tracking the same index has a much lower expense ratio of around 0.10%, or even lower. Over the long term, this difference can create a substantial difference in the value of the overall corpus. However, to permit a fair comparison, you also need to consider that transacting in ETFs requires you to have a Demat account, which comes at a certain annual fee. Plus, there are brokerage and associated costs for every transaction you make. Still, for an investment amount beyond a certain threshold, ETF can prove significantly economical than index funds.

An index fund is a comparatively more liquid product as compared to ETF. This is because an Index fund is available for purchase at any time based on the last day’s Net Asset Value (NAV). However, you can buy an ETF only during the market trading hours at a price that closely reflects the trading price of the underlying shares at the time of the transaction. When you sell an index fund, you have a ready re-purchaser in the form of a mutual fund company that will purchase at a given NAV. However, in ETF, you can only sell the ETF on the stock exchange to a willing buyer. You can find a slight delay in transaction execution in ETF in the absence of proper liquidity. And this is why it is essential to identify and invest only in highly liquid ETFs.

A great feature available to young investors in mutual funds is the Systematic Investment Plan (SIP). It helps you to put your monthly investment plan on autopilot. Then, you also have other options like Systematic Transfer Plan (STP) and Systematic Withdrawal Plan (SWP) to reduce risk and time the withdrawals. ETFs do not offer such an advantage, and you have to manually purchase and sell every time. Generally, young investors cannot spend much time, and effort managing their investments and want a simple investment solution. For them, an index fund wins hands-down over an ETF.

In index funds, you have the option to receive the dividend periodically (dividend option) or let it remain invested (by way of a growth option). In the case of ETF, a growth option is not available. You have to compulsorily receive the dividend in your bank account. This hampers the compounding process. Moreover, the hassle of re-investing the dividend back into the ETF becomes a manual process and requires a particular discipline. Many investors do not have this kind of discipline and spend the dividend amount, which negatively impacts their wealth creation process.

Ideally, the returns from the index fund or ETF should exactly match the underlying index’s return. But it does not happen from a practical perspective because of costs, charges etc. When you invest passively, your intention is not to beat the index but to ensure that your returns are as close to the index as possible. On this parameter, ETFs have the upper hand over index funds. This is because index funds generally have to keep some cash aside to meet redemption requests. On the other hand, ETFs have no such compulsion. They have the entire corpus deployed (less brokerage and other costs) into the funds.

Both index fund and ETF have their pros and cons.

If you have a demat account and can get competitive rates on your transactions, you can consider ETFs. Ensure that the ETFs shortlisted by you are liquid, low-cost, and have a low tracking error. However, do keep in mind two things as follows:

1. You need to factor in the brokerage and Demat account charges for the transaction to get a complete picture of costs.
2. You will have to invest manually and have a particular discipline to re-invest the dividend into the ETF.

On the contrary, you can prefer index funds if you do not have a Demat account and don’t wish to open one. They are a relatively straightforward way of investing systematically into equity markets. You can choose a good index fund with low cost and tracking error and start a SIP in that fund. You can also explore STP, wherein you first invest the entire money in a debt fund and then systematically move it to an index fund. Choosing a direct plan will further reduce your cost of investing.

To sum it up, you can start with an index fund if you are a new investor and are starting your investing journey. Over the years, as your income increases and you have a more significant disposable surplus to invest, you can then make a call to shift to ETFs. Do make sure to factor in all the above parameters before taking a final decision.