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Index Funds vs ETFS – What is the difference

Updated on :  

08 min read.

Index funds and exchange-traded funds (ETFs) might seem similar, but they are not the same. They are two of the most popular passive investment options. If you are not sure as to which of the two suits you, then read the following to make an informed decision:

What are ETFs?

An exchange-traded fund consists of shares that constitute widely followed indices such as NSE Nifty 50 and BSE Sensex. If an ETF is tracking a particular index, then that index would contain the same stocks like that of the index, and their weightage shall also be the same. Additionally, the ETF may also invest in money market instruments for the sake of liquidity. ETF returns are generally predictable and will be close to what its underlying index earns.

Nevertheless, despite many ETFs track the same index, their returns will not be the same as their debt holdings differ, which affect their returns. The units of ETFs are traded on stock exchanges, similar to shares.

What are Index Funds?

The asset allocation an index fund tries to replicate that of a popular index that it is trying to emulate. As index funds are not having liquidity of their own, hence they invest more in liquid securities. Therefore, index funds having tracking error. The deviation of the returns that an index fund would generate from the returns that of its underlying index is directly proportional to the tracking error.

Making Transactions

The units of ETFs can be bought and sold on the stock exchanges, as the name suggests. Therefore, if you are to invest in ETFs, then you mandatorily need to have a Demat account. A minimum of one unit has to be bought, and this can be done the same way you buy or sell a regular share on a stock exchange through a recognised broker.

The index funds are regular mutual funds. You can invest in a lump sum or systematic investment plans (SIPs) in order to buy units of index funds. Demat accounts are not compulsory to invest in index funds. However, having a Demat account is beneficial in many ways for investors.

Charges Involved

When it comes to ETF investments, there are no recurring charges. Besides Demat account’s annual maintenance charge, another cost that you as an investor would have to bear is the transaction charge, which is restricted to under 5%. When compared to ETFs, index funds have numerous charges. Transactions above Rs 10,000 are levied with a transaction fee of Rs 100.

Unlike ETFs, the index funds come with expense ratio, a recurring charge in the range of 1% to 1.8%. Investors are to pay expense ratio even if there are no transactions made. Apart from that, if you are to exit the fund within a specified timeframe, then you are liable to pay exit load.

Wholistic Comparison

ParameterETFsIndex Funds
ObjectiveTracking the performance of indices of a particular exchangeReplicating the performance of a given index
How are they traded?Traded like a stock on an exchangeUnits of index funds are issued like any other mutual funds
PricingThe pricing follows the principle of sharesThe NAV of the fund differs due to various factors
Factors affecting the priceDemand and supply for the security in the marketNAV of the fund and the assets underlying
CostA transactional fee is applicableNo transactional fee and commission
Expense ratioLow High

Conclusion

ETFs might seem to have a clear advantage over index funds as they come at a lower cost. However, you may not be in a position to track markets and take decisions accordingly. This may be due to a lack of market knowledge or time constraint. In this case, you can invest in direct index funds as they come at a lower cost than regular index funds. Also, index funds are handled by professional fund managers, and they take the right decisions depending on the market scenario.

Frequently Asked Questions

As a tax-paying citizen, Section-80C of the Indian Tax Act allows you some breather a deduction of up to 150,000 from your total annual income.

What are Index Funds in India?

Index funds are a mutual fund with a portfolio that tracks the components of a market index such as the BSE Sensex or the Nifty. It invests in stocks which make up an index in the same proportion. You may consider investing in index funds if you want returns that mirror the underlying index. It is a passive investment with lower management costs.

How to Invest in Index Funds in India?

You may invest in index funds directly with the AMC or through a mutual fund distributor. However, you may visit the branch of the mutual fund or the website of the mutual fund to invest directly with the mutual fund house.

  • You must log on to cleartax invest
  • You then select the mutual fund house from the list of fund houses
  • Pick the index fund based on your investment objectives and risk tolerance and click on Invest now
  • You must select the amount you plan to invest in the index fund and the mode as either One Time or Monthly SIP.
  • You must fill up the requisite details such as name, email ID, mobile number and complete the transaction.
How to choose Index Funds?
  • You may choose to invest in an index fund that tracks a significant portion of the market such as the Nifty 100.
  • You could look for index funds with a low tracking error. A fund with a low tracking error closely mirrors the index it tracks.
  • You could take a look at the investment cost of the index fund.
  • You may consider taking a look at the track record of the mutual fund house and the assets under management.
What are equity index mutual funds?

An equity index mutual fund invests the bulk of the corpus in stocks. It has a portfolio constructed to track a market index such as the BSE Sensex or the Nifty.

You may consider equity index mutual funds purchasing stocks in the same proportion as the index it tracks. It is suitable for the first time investors in the stock market.

What are low-cost index funds?

An index fund has a portfolio that tracks a particular market index such as the BSE Sensex or the CNX Nifty. It is passively managed and has lower management expenses as compared to actively-managed equity funds.

Why should I invest in index funds?
  • You may consider diversifying your portfolio with index funds for stability and a cushion against extreme volatility in the stock market.
  • It is passively managed and has a lower expense ratio as compared to actively-managed equity funds.
  • You may consider the portfolio of index funds tracking a particular index and offer returns that match the index. It is suitable for first-timers in the stock market.
  • You may choose index funds if it matches your investment objectives and risk tolerance. You could stay invested in index funds for the long-term.
Why index funds are better than mutual funds?

Index funds mimic a market index such as BSE Sensex or Nifty and give returns that match the index. It is passively managed and has a lower expense ratio as compared to actively-managed funds.

You may consider fund managers of actively-managed equity funds seeking to generate a higher return as compared to a benchmark index. However, studies have shown that index funds may perform better as compared to actively-managed equity funds over the long-term.

What are Nifty Index Funds?

You may consider Nifty Index Funds as index funds that actively track the Nifty. It has a portfolio of 50 stocks that comprise of the Nifty in the same proportions. Nifty Index Funds may offer returns that match the Nifty.

How to buy and sell Index Funds?

You could invest in index funds directly with the asset management company. You may also consider investing in index funds through a mutual fund distributor. However, you may invest in index funds directly with the mutual fund house for a lower expense ratio.

The cut-off time would determine the NAV (Net Asset Value) when buying and selling the units of the index fund. An index fund may be available for sale or purchase only at the end-of-day.

How to invest in US index funds from India?

You may consider investing in US index funds from the comfort of your home in India. You could invest in US-focused index mutual funds that track the S&P 500 Index or the Nasdaq 100.

You could invest in US index funds through an asset management company (AMC) in India. Many AMCs in India have launched index schemes that track US market indices such as Nasdaq 100 and the S&P 500.

You may approach the fund house and complete your KYC with a KRA (KYC Registration Agency) before investing in US index funds.

What are Exchange Traded Funds?

Exchange-Traded Funds or ETFs are passive mutual funds which track a market index such as BSE Sensex or the Nifty. It is a basket of stocks which replicates an index. You may consider ETFs to be similar as compared to index funds.

However, ETFs are listed on the stock exchange and may be traded throughout the day like stocks. You may buy and sell index funds only at the price that is set at the end of the trading day.

Why Index funds are not popular in India?

Indians prefer actively-managed equity funds as compared to index funds. It is because fund managers in India may generate a higher return with actively-managed equity funds, as compared to index funds.

Mutual fund distributors may not promote index funds as they earn a higher commission from actively-managed equity funds. However, you may find investors preferring index funds in developed economies such as the USA.

What is tracking error in index funds?

You may consider the difference between the returns from index funds and the benchmark index as the tracking error. You may consider picking an index fund that has an extremely low tracking error which signifies a well-performing index fund.

You could find a tracking error in index funds as it tracks a dynamic index whose constituents may change. For example, the Nifty could have added or removed some stocks from the index. The fund manager of the index fund may take some time to replicate the change leading to a tracking error. Moreover, index funds may face extreme redemption pressure which could lead to a tracking error.

What is a benchmark index for mutual funds?

The performance of a mutual fund is measured against its benchmark index. You may consider the Nifty 50 to be a relevant benchmark index for large-cap funds. However, you should consider comparing the performance of a mutual fund against the benchmark over the long-term.

The benchmark index is a group of securities which is used to measure the performance of other securities. For example, the BSE Sensex and the Nifty are examples of a benchmark index. You may find mutual funds tracking the portfolio of the benchmark index in the same proportions to replicate the returns. These mutual funds are called index funds. You may use the benchmark index as a yardstick to measure the performance of mutual funds.

How do Index Funds work?

An index fund is a passive investment where the fund manager doesn’t have to pick the stocks. You may find the portfolio of index funds mimicking a particular index such as the BSE Sensex or the Nifty. You could get returns which match the relevant index.

For example, you invest in an index fund that tracks the BSE Sensex. The NAV (Net Asset Value) moves in-line with the index it tracks. If the BSE Sensex rises by 5% in a month, you may find the index fund linked to the Sensex offering a similar return over the same period. However, if the BSE Sensex drops by 10% you may find the NAV of the index fund falling by around 10%.

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