The most common question every investor has - What is the difference between ETF and Index Fund ? As both the instruments are the source of investing in the index, the people usually ask is which one is better. In this article, we will see what's the real difference is and which one fits you best. But before that, let us briefly understand what ETF and Index Funds are and what are their similarities.
Exchange Traded Fund (ETF)
An ETF is basically a basket of securities which are held by the sponsored fund (generally are large institutions, for eg- HDFC Securities), who issues the shares of the funds with keeping that basket of securities as underlying. In a simple language, a large institution buys some different securities in a particular proportion and creates a basket of these securities. Later that institution issues its own units in the open market for trading/investment purpose, keeping that basket of securities as underlying. This basket of securities generally represents a particular index but sometimes can be different also.
Just like another stock - ETF are traded on the exchange and gives you the opportunity to short sell or even purchase on margin.
Index Fund is a category of a mutual fund, where the fund is passively managed and therefore has a very low expense ratio. The fund manager doesn't have to take the decision actively for selecting, purchasing or selling a security. Rather, these funds track a predetermined index by investing in the same securities and in same proportions.
Intra-day trading, short selling or buying on margin is not possible under index fund. Their NAV settlement takes place at the end of the day. In fact, if you sell the index fund units before a particular time period, then you might have to pay an exit load.
Similarities between ETF and Index Funds
- Both Index Funds and ETFs are classified under the head of ‘indexing’ as it involves investing in an underlying benchmark index. The objective is to beat actively managed funds in multiple ways.
- They have low expense ratios compared to actively managed funds
- Funds are managed professionally and aim to reduce risks through diversification.
- They have a Net Asset Value determined as total value of the underlying assets minus fees divided by total number of shares
Differences between ETF and Index Funds
- The major difference between an index mutual fund and an ETF is that an investor investing in an index mutual fund buys the fund shares directly from the fund and the settlement for all investments take place at the net asset value. In the case of an ETF, however, investors buy the shares from other investors just as if they were buying or selling shares of stock.
- The pricing for ETF takes place throughout the trading day. It is based on the prevailing price at the time the transaction was made. This price may or may not be equal to the net asset value (NAV) at the time, but it represents the price at that time for a willing buyer and seller. On the other hand, the index fund gets priced at the closing of the trading day and is always equal to its NAV.
- Expenses are lower for both the instruments but unlike Index Fund, ETF does incur brokerage fees and therefore its trading makes it a little more expensive compared to Index Funds.
- The minimum required investment in an ETF is usually smaller. Investors can purchase as little as one share in an ETF, which is usually not the case with an index mutual fund. In the Indian market, index funds require a lumpsum payment of Rs.5000 or Rs.500 if the SIP (Systematic Investment Plan) is accepted. Investment through SIP is not applicable for ETF’s.
- In the case of the ETF, dividends are paid out to the shareholders whereas index mutual funds usually reinvest the dividends. Hence, there is a direct cash flow from the ETF that is not there with the index mutual fund.
- ETF's intra-day pricing enables traders to transact with greater flexibility and liquidity comparing to index funds.
- A trading/brokerage account is essential for buying and selling of ETF’s but no such requirement in case of an index fund.
- ETFs are often cited as having tax advantages over index mutual funds. The advantage is related to the capital gains and not to dividends. As long as there is no sale of assets in either fund, no taxable capital gains would be realized by investors. However, because of the flow of funds into and out of index mutual funds, there is a possibility that these funds might have to sell their holdings to meet those liabilities. Therefore Index Fund has a greater chance of generating taxable capital gains for investors
- ETF don't involve any entry/exit load but it charge the brokerage, management fees, and taxes. On the other side, the Index fund involves management fees and exit load is applicable in case of liquidation before a particular time.
- Trading of ETF’s reflect the real-time environment of the market. But ETFs are susceptible to manipulations because they are not directly associated with the NAV, they are which may not be acceptable to risk-averse investors with preference to stable investment. Index funds cannot be sold short and generally offer more stability for conservative investors.
With the above comparison, we can conclude that both the ETF and the Index Funds have their benefits and drawbacks. Both the instruments are a good source for investing in the index but their preference by the investors could differ. The investor who wants more flexibility, liquidity or just wants to take a short time position will choose ETF. Whereas the investor who wants to invest for the long term in a diversified portfolio, with a small capital and the least efforts in managing that capital should consider Index Funds. Also to avoid the comparatively higher expense and brokerage charges, the small retailers may select index fund over ETF.
One important thing to consider while investing in ETF is that if you want to sell your shares, you’ll need a counterparty, which will purchase from you. But the problem is that ETF is still not that popular in India, so you might not be able to liquidate your position immediately. On the other hand, in case of index fund you can directly sell your units, and can get the money from the mutual fund by the end of the next day.