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.
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.
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.
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.
ETFs | Index Funds |
---|---|
You need to have demat and trading accounts with stock brokers to invest in ETFs | Anyone can invest (if you are KYC compliant). You do not need demat account. |
After NFO subscription period, ETFs can be bought or sold only on stock exchanges, unless transactions take place in lot sizes (creation units) as specified by the Asset Management Companies (AMCs). If you are transacting in lot sizes, you can buy / sell directly with the AMC. However, the ETF lot sizes are usually quite large compared to average transaction size of retail investors. | You can invest or redeem with the AMC like any open ended mutual fund. |
You can buy one or more units of ETFs in the stock market / exchange. Therefore, minimum investment amount in ETFs is price of one unit. | The minimum amount for one time purchase (e.g. Rs 5,000) and additional purchases (e.g. Rs 1,000) is specified in the Scheme Information Document (SID). |
There is no Systematic Investment Plan (SIP) facility for ETFs. However, some stockbrokers may provide SIP like facilities for investing in ETFs. | You can invest in Index Funds through SIP. The minimum SIP amount is specified in the SID. |
ETF transactions take place on current market prices in stock exchanges just like stocks. The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. | Index fund transactions are based on end of day NAVs. |
ETF costs are usually lower than Index Funds. However, you also have to incur costs like brokerage, STT, GST, stamp duty etc. | Index fund costs are higher than ETFs, but lower than actively managed mutual funds. |
ETFs do not have any Income Distribution cum Capital Withdrawal (IDCW) options. | Index funds have growth and IDCW options and investor may refer SID to know more about the scheme plans available. You can decide which option you want based on your investment needs. |
Let us discuss some of the key differences between ETFs and index funds in more details, so that you can make informed investment decisions.
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.
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.
An Investor Education and Awareness Initiative by Mirae Asset Mutual Fund.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.