ETF versus Index Funds

Passive funds are rapidly gained popularity all over the world in the last 2 decades, especially in developed markets like the US. Passive equity fund assets under management (AUM) has already overtaken active equity fund AUM in the US. Bloomberg has predicted that passive AUM will cross overall active AUM in the US by 2026.

What are passive funds?

Passive funds invest in a basket of securities which replicate a market benchmark index. Weights of securities in the fund mirror the weights of the constituents in the index. Unlike actively managed mutual funds, passive funds do not aim to beat the market. There are two types of passive funds – exchange traded funds (ETFs) and index funds. In this article, we will discuss about ETFs and index funds; compare and contrast ETFs vs Index Fund.

What are Exchange Traded Funds?

Exchange traded funds (ETFs) are passive schemes tracking market benchmark indices like Nifty, Sensex etc. ETFs do not aim to beat the market benchmark index they are tracking; they simply aim to give benchmark market returns. ETFs are listed in stock exchanges and trade like shares of companies. You need to have Demat and trading accounts to invest in ETFs.

What are index funds?

Index funds are also passive mutual fund schemes which track market benchmark indices like Nifty 50, Sensex etc. Index funds are very similar to ETFs but with one major difference between index fund vs ETF. Index funds are like any other open ended mutual fund scheme. You do not need Demat and trading accounts to invest in index funds.

Benefits of passive funds – ETFs and index funds

• Low cost: Since passive funds (ETFs and index funds) invest in basket of securities that replicate the benchmark index, the effort and resources required for research and fund management are considerably lower than that is required for actively managed mutual fund schemes. As a result, the Total Expense ratios (TERs) of passive funds are much lower than actively managed funds. The fund manager of an active fund will have to generate significant alphas on a consistent basis to match the performance of a passive fund tracking the same benchmark index. Suppose the TER of an active fund is 2%, while that of a passive fund tracking the same benchmark index is 0.25%. This cost difference between ETF and index fund implies that the actively managed fund will have to consistently beat the benchmark by at least 1.75% to match the performance of the passive fund. Over long investment horizons, lower costs may result in considerably higher returns due to the compounding effect.
• No unsystematic risk: This is another difference between index fund and ETF. In order to beat the index (create alpha), the fund manager of an actively managed mutual fund will have to be overweight or underweight on certain stocks in the index. This will result in unsystematic i.e. stock or sector specific risks. While unsystematic risk may lead to outperformance, it can also result in underperformance. Unsystematic risk is an additional risk in investment over and above market risks. There is no unsystematic risk in passive funds. Passive funds are subject to market risks.
• No human behavioural biases: Fund managers are humans like the rest of us and they may have behavioural biases which may reflect of fund performance. Moreover, the fund manager of an active fund can change for a variety of reasons, other than performance. This can affect the returns of the fund. There is very little human bias in passive investing. This is another important difference between index fund and ETF.

ETFs versus Index Funds

Let us discuss some of the key differences between ETFs and index funds in more details, so that you can make informed investment decisions.

ETFs versus Index Funds – Liquidity

Unless you are transacting in lot sizes, you can sell your ETF units only in the stock exchanges. In order to sell your ETFs units, there must be buyers for your units in the market. AMCs appoint market makers for their ETFs. The market makers are large stockbrokers, who try to ensure the liquidity of the ETFs in the market. However, in certain market conditions investors may not find sufficient buyers for some ETFs or they may be forced to sell units of their ETFs at a lower price. ETFs may have liquidity risks and therefore, you should invest in ETFs that usually trade in large quantities i.e. high average daily trading volumes – these ETFs will have higher liquidity. Liquidity is not an issue with index funds because you can redeem your units with the AMC at any time.

ETFs versus Index Funds – Price

ETF units trade in stocks exchange like shares of listed companies. You can buy / sell units of your ETFs at current market price. You will buy or sell ETF units based on offer (ask) or bid prices in the exchange. Offer is the price at which traders will sell ETF units to you. Bid is the price at which traders will buy ETF units from you. The offer price will usually be higher than the bid price. Bid / offer prices may be different from the NAV. The difference between the offer and bid price is known as the bid ask spread. The bid ask spread for highly liquid ETFs is less than the bid ask spread of less liquid ETFs. Larger the bid ask spread higher is deviation from the NAV. The bid ask spread also depends on market conditions. In extreme bear markets, the bid price may be significantly lower than the NAV. Unlike ETFs, index fund transactions (buy / sell) take place on the basis of prevailing end of day NAVs.

Where should invest – ETFs versus Index Funds?

• Demat account: You need to have Demat and trading accounts to invest in ETFs. If you do not Demat and trading accounts, then you can invest in index funds. However, this should not be only consideration. Let us discuss the other factors.
• Cost: Cost of ETFs including the transaction costs like brokerage, STT, GST, stamp duty etc are lower than Index Funds. Purely from a cost viewpoint, ETFs may have an advantage if you compare ETF vs index fund.
• Tracking error: Tracking error is the deviation of the returns of ETFs and Index Funds from the benchmark index returns. Standard deviation of the differences in monthly returns of the ETFs and index funds and the market benchmark index is defined as tracking error. There are various sources of tracking error e.g. fees and expenses of the scheme, cash balance held by the scheme due to dividends received, halt in trading on the stock exchange due to circuit filter rules, etc. Tracking errors of ETFs are usually lower than that of index funds because of lower TERs and cash holdings.
• Liquidity: This is a very important consideration because you can sell ETF units only in the stock exchange (unless you are redeeming in lot sizes which are usually quite large). Some ETFs are quite liquid, while others may not be liquid. You have to look at average daily trading volumes of your ETF to get a sense of its liquidity. Liquidity also depends on market conditions. This may require some investment experience. Liquidity is not an issue with index funds because you can redeem with the AMC. This is an important factor if index fund vs ETF is compared.
• Experience: If you have investment experience in the stock market buying and selling stocks, then investing in ETFs will be easier for you because ETFs are very similar to stocks. You should know about different types of orders (e.g. market order, limit orders etc), understand bid / offer prices, understand trading data (price, volume data) etc. Index funds, on the other hand, are mutual funds. As such, they have all the factors that are associated with mutual funds e.g. convenience, flexibility, investing through Systematic Investment Plan / Systematic Transfer Plan etc.

 

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.