Comparing index mutual fund and ETF is similar to apple versus apple comparison. We shall compare index mutual funds and ETFs since both are essentially passive strategies to invest in the markets. But what exactly is passive investing? As the name suggests, the very purpose of passive investing is to remain passive and just mirror. Unlike active strategies, the focus of passive is not to beat the index but just track the index with minimal tracking error.
Index funds and ETFs; two popular passive methods
In the Indian context, any investor looking to invest passively has two broad choices viz. Index Funds and Index ETFs. While they are structurally similar, there are some subtle differences between the two. But first the concepts!
An index fund is like any normal mutual fund scheme. The only difference is that the fund manager just creates a portfolio that replicates an index (Sensex or Nifty). There is no element of stock selection in an index fund. The only effort the fund manager puts is to ensure that the tracking error is kept at the bare minimum so that the performance of the index fund mirrors the index as closely as possible.
An Index ETF refers to the fractional issue of shares on the index. An ETF is akin to a closed end fund where the funds are raised in the beginning and then the ETF creates a portfolio of index stocks to mirror the index. If the Nifty ETF is 1/100th fractional unit then one unit of the Index ETF will roughly be available at Rs.110.85 assuming the Nifty level at 11085. In reality there will be a minor divergence to reflect costs and some cash holding.
What drives the choice – Index Funds versus Index ETFs?
In fact a number of factors can go into the decision whether you should go for a passive approach via index funds or via index ETFs.
- Inflows into an index fund from an AMC it adds to the AUM of the Fund and outflows reduce the AUM of the fund. On the other hand, when you buy an Index ETF it does not add to the AUM of the ETF but the units just change hands like a normal share. Therefore, availability of liquidity is important in an index ETF.
- An index fund is available for purchase or sale based on EOD-NAV. Index ETFs are available to buy and sell during the trading hours at a price that reflects the Nifty fraction at point of time. This gives greater flexibility to the Index ETF buyer and such investors in ETFs can capture the volatility better.
- Expense ratio in an Index ETF is much lower compared to the index fund. Just to cite an example, if index fund has an expense ratio of around 1.00% then an index ETF would have an expense ratio of about 0.35%. But this is just the expense ratio debited as TER to your NAV. In addition, index ETF also entail brokerage and statutory costs to execute the trade.
- Both Index ETF and Index funds only carry market risk (Beta) but there are 2 key risks you must be familiar with. There is the tracking error risk which is higher in case of index funds as they need to keep larger cash balances. On the other hand, Index ETFs run a higher risk of bid-ask spreads widening when markets get volatile.
- You can do automated SIP in index funds but cannot do automated SIPs in ETFs. SIP gives the added benefit of rupee-cost averaging which lowers your average cost of owning the units. That is because, ETFs are closed end funds.
- What about the tax treatment? On the taxation front, there is not much to choose between the two. Like in case of index funds, Index ETFs also are charged STCG at 15% and LTCG at 10% (above Rs.1 lakh per year). Such equity oriented funds are treated as equity funds for tax purposes.
In a nutshell, there are two important criteria you need to consider when making the choice between Index ETFs and Index Funds. They are cost and liquidity. If liquidity is easily available in the secondary markets without too much of a basis risk, then the lower costs will work in favour of the Index ETFs.
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