Index Fund vs ETFs: What Are the Differences?
For mutual funds, there are two investment styles through which individuals can invest their money in the market. Namely, they are active and passive investment strategies. When investors choose to invest in an actively managed mutual fund, investors are handing money to a fund manager who will manage their investment according to their expertise.
In passive investments, a fund manager creates a portfolio that mirrors indices like Nifty 50, Sensex, etc. ETF and Index funds are two popular passive investment options. This blog aims to cover the differences between ETF and index funds.
What Are ETFs?
ETFs or exchange-traded funds are funds that are traded on stock exchanges. This means investors can sell their fund units to get profits instead of redeeming them. All ETFs track the performance of their respective indices. Thus, ETFs carry the features of both stocks and mutual funds.
It is similar to stock because it is tradable, and its prices fluctuate constantly. Investors who purchase an ETF can also set a limit order. These are highly transparent, and because of the transparency, investors will know exactly where their investments are allocated.
ETFs are also similar to index mutual funds because ETFs like Nifty ETF will track the Nifty index. This means Nifty ETF will have a composition similar to Nifty index funds, and the funds will be allocated in the same stocks. Moreover, the performance of an ETF will mirror its index. This investment option also invests its corpus on money market instruments to enable liquidity.
Furthermore, the transaction takes place on a real-time basis, which is why it is affected by market conditions. Examples of exchange-traded are bond ETFs, industry ETFs, gold ETFs, liquid ETFs, etc.
What Are the Characteristics of an ETF?
A few common characteristics of ETFs are listed below:
- The total expense ratio of exchange-traded funds is very low, but they incur transaction charges.
- These funds are very similar to stocks and are traded daily, so investors need to create a demat account to invest in ETFs.
- The dividends that investors receive from ETFs can be reinvested into the market.
- Investors will get regular information about their portfolios if they invest in ETFs.
- Investors can buy or sell ETFs at any time without any limitations.
What Are Index Funds?
Index funds are a passive investment option where the asset allocation is done such that it becomes a replica of the index it is trying to mimic. Fund managers do not select the industry or stocks to invest in. Instead, they purchase stocks and other instruments by following an index.
Index funds enable investors to invest in risky investments as it mitigates their risks by following the market. The fund manager’s role in an index fund is to ensure the investments do not fall from the benchmark.
Moreover, index funds generally trade replicating the popular indices like the Sensex or Nifty 50. Therefore, investors who want to create wealth over a longer period tend to invest in index funds.
Also Read: Equity Funds vs Debt Mutual Funds
What Are Some Characteristics of Index Funds?
The characteristics of index funds are stated below:
- Since index funds are a type of open-ended mutual fund, investors can redeem or invest at any time according to their convenience.
- Fund managers maintain the fund units in an index fund on behalf of investors. Therefore, the fund manager has to maximise profit by replicating the index performance.
- Investors can invest as per their risk appetite for investments as there are a variety of index funds available replicating various indices.
What Are the Differences between ETF and Index Funds?
The following factors differentiate ETFs and index mutual funds:
|Trading||ETFs are traded like shares on the stock exchange.||Investors are issued fund units just like any other mutual fund in the market. These units are not tradable.|
|Demat requirement||Demat is required for trading in ETFs.||Demat is not necessary for trading in Index Funds.|
|Liquidity||ETFs generally have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors.||Investing and selling fund units in an index fund is very easy. But instant buying and selling won’t be possible.|
|Cost||Investors will have to pay a nominal transaction fee. Total costs are lower.||The expense ratio will be charged.|
|Expense Ratio||The total expense ratio of ETFs is low.||The total expense ratio of index funds is higher than that of ETFs.|
|Factors affecting the price||The availability of sellers and buyers in the market can affect prices.||NAV of the underlying assets and funds.|
|SIP Availability||ETFs do not provide SIP options for investors.||SIP mode of investment is applicable in index funds.|
What Are the Similarities between ETFs and Index Funds?
Now that you know the difference between ETFs and index funds let us learn about the similarities between the two passive investment tools:
- Low Fees- ETFs and index funds have lower expense ratios than most mutual funds because fund managers do not actively manage them. They do not spend efforts on research and analysis to outperform the broader market. The funds mimic the benchmark index. Since their total expense ratios are lower, investors can generate slightly higher returns than actively managed funds.
- Long-term gains- Historically, it has been seen that passively managed funds perform better for long-term investments as compared to actively managed mutual funds on average. According to the S&P’s SPIVA report, 82% of active large-cap schemes underperformed the benchmark over a 5-year period that ended December 31, 2021.
- Diversification- ETFs and index funds allow investors to diversify their portfolios. The investor will be exposed to numerous types of securities available in the market through these two investment options.
Moreover, the effect of market volatility on the fund’s performance is relatively lower compared to individual stocks. For example, if an ETF you invested your money in mimics the Nifty 50 benchmark, there is a high chance that your losses will be limited.
Individuals who actively trade in the share market tend to invest in ETFs. If you are one of those people who prefer flexibility and want to buy or sell your investments quickly, you can opt for ETFs. Furthermore, ETFs are traded like stocks in the market, so you can use trading facilities such as margins, stop loss orders and limit orders.
On the other hand, if you choose to be a more passive investor, you can rely on index funds for long-term wealth creation. Moreover, you can invest in such funds via SIPs to make your investments more affordable. Both options are very similar, but knowing the differences between ETFs and index funds will help you make the right choice for your needs.
Frequently Asked Questions
What are the benefits of ETFs?
The benefits of ETFs are as follows:
Investors can easily purchase and sell ETFs just like any other stock on the exchange through various terminals from anywhere in the country.
The minimum investment amount is very low.
Investors are not required to file numerous forms and can call their brokers to invest in ETFs.
It has the flexibility that stocks provide and index funds’ diversification quality.
What are the benefits of investing in index funds?
The benefits of index funds are as follows:
Investors do not need to be experienced to start investing in index funds.
The total expense ratio of index funds is low.
These funds are easier to manage as they replicate a benchmark index.
As they replicate the benchmark, the risk of underperformance compared to underlying indices is eliminated.
As they give significantly high returns compared to FDs over the long term, they can be used for long-term wealth creation.
What are the risks associated with investing in index funds?
A few risks associated with investing in index funds are:
One of the major risks associated with investing in an index fund is tracking errors. An index fund may not track its index properly, which can be quite risky for investors.
Index funds are not as flexible as other non-index mutual funds in the market.
These funds can not outperform the market and generate high alpha as they mimic the indices.
Index funds may not perform well in the short term due to market fluctuations, so investors usually have to stay invested long. However, this is unsuitable for investors with a short to medium-term investment horizon.
Should I invest in ETFs or index funds?
If you are looking for higher liquidity, you can invest in ETFs. However, as an investor, if you are looking for passive investments using SIPs, then opt for investing in index funds. Both are similar, but it depends on your financial goals and requirements.