Difference between ETF and Index Fund

ETF and Index Funds Comparison

The most common question every investor has - What is the difference between ETF and Index Fund ? As both the instruments are a very good source of investing in indices, investors usually ask which one is better. In this article, we will see what's the real difference between them and which one fits you best. But before that, let us briefly understand what are ETFs and Index Funds and their similarities.

Exchange-Traded Fund (ETF)

An Exchange Traded Fund is basically a basket of securities that are held by a sponsor fund, usually large institutions which issue the units or shares of the fund to the investors while keeping the different constituent securities as underlying. In layman terms, a large institution buys different securities with varied proportions to form a basket or portfolio of securities. Later, the institution issues its own units in the open market for trading & investment purposes. Most of the ETFs track or replicate the performance of a particular market index but sometimes it can be different.

Just like other stocks, ETFs are traded on the exchange. Similar to  stocks, investors have the opportunity to buy, short sell, or even make purchases on margin in ETFs as well.

Index Fund

Index Fund is a category of mutual funds, where the fund is managed passively and therefore, comes with a very low expense ratio. Here, the fund manager doesn't have to actively make decisions regarding the purchase, additions, or selling of the underlying securities. Rather, these funds aim to replicate the performance of a pre-defined index by making investments in the same securities and in the same proportions.

Unlike ETFs, the facilities of Intra-day trading, short selling, or buying on margin is not provided to the investors in index funds as they do not trade on exchanges. Their NAV (Net Asset Value) settlement takes place at the end of the business day. In fact, if you sell the units of an index fund before a pre-defined time period, then you might have to pay an exit load as specified.

 

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

  • Parties involved: One of the major differences between an index fund and an exchange-traded fund is that an investor investing in an index fund directly buys the units from the mutual fund in which the settlement for all investments takes place at the NAV of the fund. Whereas in ETFs, investors purchase the units from other investors in the market just like buying or selling of stocks.
  • Transaction price: The pricing for ETFs takes place throughout the trading time period on a business day. The price for an ETF unit is based on the prevailing market price at the time the transaction is being made. This price may or may not be equal to the NAV at a given point of time, but it represents the price at which the willing buyer and sellers could enter into a transaction. On the other hand, an index fund is priced at the closing of every business day and is always equal to their NAV.
  • Expense ratio: Expenses are on the lower side for both the investments compared to active funds.But unlike index funds, ETFs does incur brokerage charges and therefore makes it a little more expensive compared to the index funds.
  • Minimum investment: The minimum amount required to make investment in an ETF is usually lower. Investors can buy as little as one share in an ETF, which is usually not possible in index mutual funds. Index funds require a minimum investment of Rs.100 both in case of lump-sum or SIPs. However, the amount varies across funds. Investments through SIP mode cannot be made in ETFs.
  • Dividends: In case of ETFs, dividends (from underlying securities) are directly paid out to the shareholders whereas in index mutual funds, dividends are usually reinvested into the fund to further generate more returns. Hence, there is a direct cash flow from the ETFs to the shareholders which doesn't happen in the case of index mutual funds.
  • Flexibility: The updates in ETFs prices throughout the day enables the traders to make transactions with greater flexibility and more liquidity as compared to the index funds.
  • Demat account: A trading or demat account is essential for the purchase or selling of ETFs but investments in index funds does not require any demat or trading account.
  • Tax advantage: ETFs are often cited as having tax advantages over index funds. The tax advantage is related to the capital gains and not the dividends. As long as there is no selling of underlying assets in either fund, no taxable capital gains would be realized by the investors. However, because of the flow of funds by investors into or out of the index funds, there are possibilities that these funds might have to liquidate or sell their holdings to meet the redemptions by the investors. Therefore, index mutual funds have a higher chance of generating taxable capital gains for the investors.
  • Costs: ETFs don't involve any entry or exit loads but it does involve expenses like brokerage, management fees, and taxes. On the other hand, the index funds involve the cost of management fees as a part of the expense ratio and along with that exit loads are also applicable in case of the liquidation of holdings by the investor before a specified time period.
  • Suitability: Trading in ETFs reflects the real-time environment of the market. But at the same time, they are susceptible to high fluctuations which might not be acceptable by the risk-averse investors with preference to stable investment & lower volatilities in their investments.

Except for buying & selling, other transactions like short selling, trading on margins do not take place in index funds. Also, the price of a unit is updated only once a day and hence, they offer more stability for the conservative investors.

Conclusion

With the above comparison, we can conclude that both ETFs and Index Funds have their own advantages and drawbacks. Both the funds are good options to make investments in the indices but their suitability to the investors would vary as per their needs & risk preferences. The investor who wants to have more flexibility, liquidity or have a short investment horizon will choose an ETF. Whereas, an investor who wants to invest for a long term in a diversified portfolio, with a small capital and prefers passive investing strategy could consider Index Funds. Also to avoid the comparatively higher costs including the brokerage charges, the small retail investors may consider index funds over ETFs.

One more important thing to consider while making investments in ETFs is that if you want to buy/sell your shares, you’ll need a counterparty to complete the transaction which will sell/buy from you at the market price. ETFs are still not very popular in India, which means you might face difficulties in liquidating your holdings on the desired time. On the other hand, one can directly buy or sell the units to the fund itself in case of index funds.

More Information:

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