Index Funds or ETFs: Which one to invest in and why?

A smart investor would want to play safe and mirror the Nifty 50 index instead of selectively picking his/her portfolio.

Extensive research has shown that most investors do not generate more returns on their portfolio than a bank’s fixed deposit over a longer time frame, let alone beat the returns of the national index. Therefore, a smart investor would want to play safe and mirror the Nifty 50 index (for an investor based in India) instead of selectively picking his/her portfolio. Firms offer ways to just buy the Nifty portfolio pool at once instead of replicating the entire index company-to-company:- the two most popular products are ‘index funds’ or ‘exchange-traded funds’ also known as ‘ETFs’. Both of these methods are known as ‘indexing’ and are considered ‘passive investing’ compared to actively managed mutual funds. The benefits and disadvantages of the Nifty index funds and the Nifty ETFs shall be covered in this article.

What is an index fund?

An index fund is similar to any other normal mutual fund, except that a fund manager just creates a portfolio to replicate the index instead of carefully researching and putting together his/her portfolio. However, the fund manager will have to ensure that the tracking error is kept at the bare minimum, i.e. ensure that the index fund’s extent does not mirror the index as low as possible. A zero tracking error indicates the perfect mirroring of the index.

What is an exchange-traded fund?

An Index ETF is fractional shares of the index. An ETF is a closed-ended fund where the funds are raised and then a portfolio of index stocks at the back-end is created to mirror the index. The most prominent example of an index ETF in India is the Nifty BeEs mirroring the Nifty 50 and Bank BeEs mirroring the Nifty Bank. The distinguishing factor of the ETF from the index fund is that the ETF has to be mandatorily listed on the stock exchange (traded on the exchange, hence the term exchange-traded) so that it is available to be bought and sold, just like equities in the market.

Comparison between index funds and exchange-traded funds.

Apart from these basic differences, index funds and exchange-traded funds can be differentiated based on:-

  1. Transactions:- ETFs can also be traded intraday unlike an index fund, which can only be bought or sold after the end of the trading day.
  2. AUM:- Assets under Management (or AUM) will increase or decrease in index funds depending on how many units are bought and sold – it’s not a ‘price’ like that of ETFs.
  3. Dividends:- Since ETFs are traded like stocks, any dividends will be directly transferred to your bank account. In an index fund though, dividends can be manually reinvested. This is one of the advantages of index funds over ETFs.
  4. Capital gains tax:- You will be selling the ETF from another investor who will be buying the ETF on the open market just like another stock; capital gains tax will be only yours to pay. On the contrary, to cash out of an index fund, you must redeem from the fund manager, who will then have to sell those shares to pay you the cash. The net gains (if any) are passed on to every investor with shares in the fund.
  5. Price fluctuations:- Share price of index ETFs fluctuate through the day as they are bought and sold, while the index funds are traded only once the markets are closed.
  6. Transaction and maintenance fees:- Index funds have to pay fund managers a recurring amount for maintenance and additional charges for transactions, while ETFs have lower charges for transactions, similar to stocks, and no recurring amounts.
  7. Utility:- While index funds are typically used for gathering a savings corpus for a retirement fund or long-term wealth creation, ETFs can be used in trading strategies as well as the above.
  8. Expense ratio:- On average, an index fund has an expense ratio of 1.25% while an index ETF has an expense ratio of 0.35%. This means that ETFs can translate to higher returns over time, and adds to another massive advantage that index ETFs have.