A take on Index Funds and ETFs

Before I take you on this educational tour of the two heavyweight investment products, I must confess my love. As an avid investor, if not for the idiom, ‘don’t put all your eggs in one basket’ and the emanating concentration risk because of it, I would have happily invested a good chunk of my money only in an Index Fund. I started investing in Index Funds a few years back and am in complete awe of the product for my investments.

But what you will read ahead should help you form an independent view of your preference.

Keep reading!

Forms of investing

Let’s understand a long-standing debate on active vs. passive investing in the investment community.
Active investing is a hands-on approach that requires a portfolio manager or an active participant to make investment decisions. The aim is to beat the stock market’s average returns by taking advantage of short-term price fluctuations. Historically, this investment approach has been popular during market upheavals.

Passive investing, on the other hand, takes a buy-and-hold mentality. Passive investors track a group of investments called indices. It is cost-effective as it involves less trading. The goal is to replicate the market’s success over the long haul, thereby resisting the temptation to react tactically, i.e. to short-term market moves.

The introduction of Index Funds in the 1970s made achieving returns in line with the market much easier. In the 1990s, Exchange-Traded Funds (ETFs) that track major indices simplified the process even further. They allowed investors to trade index funds as though they were stocks.

Maintaining a well-diversified portfolio is important to successful investing, and passive investing via indexing enables investors to achieve diversification.

Overview of the investment industry in India
As of March 31, 2024, the Indian mutual fund industry’s assets under management (AUM) are an impressive ₹53.40 trillion. In the last ten years, the AUM has surged from ₹8.25 trillion to the current levels, a remarkable six-fold increase.

The AUMs of ETFs and Index Funds stood at ₹6.6 trillion and ₹2.13 trillion in March 2024, respectively. This totals a passive fund AUM of ₹8.77 trillion, i.e. 34% of the total equity fund AUM. Total passive AUM rose 34% year over year last year, while equity fund AUM grew 54% in the same period.

About Index Funds and ETFs
Index Funds are an excellent choice for investors seeking a passive investment approach. These funds are designed to mirror the returns of an underlying index, such as NIFTY or SENSEX. In India, the top five Index Funds have cumulative AUMs of ₹0.42 trillion, less than 1% of India’s total mutual fund AUMs. On average, the annualised returns have been 17-20% over the last five years.

Exchange Traded Funds (ETFs), on the other hand, are essentially Index Funds that are listed and traded on exchanges (like stocks). They enable investors in different countries and specific sectors to gain wider exposure to the entire stock market with ease and on a real-time basis. An ETF is a basket of stocks that reflects the composition of an Index such as S&P CNX Nifty or BSE Sensex. Think of it like a mutual fund that you can buy and sell in real-time at a price that changes throughout the day. The top 5 ETFs in India have cumulative AUMs of ₹0.47 trillion, i.e. again, less than 1% of India’s total mutual funds AUMs. On average, the annualised returns have been similar to Index Funds (i.e.15-18%) over the last five years.

Even though both Index Funds and ETFs qualify as passive investments, there is a subtle difference between the two. An index fund can be invested in like any mutual fund. However, to invest in an ETF, one requires a DEMAT account. This is the basic difference between the two.

Tracking error
At this point, it is also important to understand another aspect called tracking error. It measures the performance of an index fund relative to the underlying index.

It is calculated using the difference between the index and the fund’s returns. A low tracking error is a good measure of an effective fund performance relative to the index it replicates.

There are three main reasons why there should be a difference between the two returns.

Expense ratio: AMCs incur costs when they run a fund, and the expense ratio of that fund measures it. The higher this ratio, the higher the tracking error would be from the performance of the index
Cash balance: All funds maintain cash balances to ensure liquidity in the fund for honouring investors’ redemptions from time to time. This leads to some differences in fund and index returns
Illiquid stocks: Some of the funds’ underlying stocks can be illiquid, impacting their tradability (less liquid stocks mean higher prices) and leading to differences between the fund and index returns.

Limitations and advantage

While comparing with Index Funds, there are certain limitations of ETFs.

Since ETFs are bought and sold like stocks, investors must pay ‘other charges’. These are transaction charges, GST, SEBI charges, and stamp duty. These additional charges bring an ETF’s returns down compared to an Index Fund. However, the concept of expense ratio is applicable in both cases.
ETFs have both end-of-day NAV and the traded price. The price at which investors invest can be different from the end-of-day NAV. If the investment price is higher than the end-of-day NAV, the investor will get a lower return. However, if the purchase price is less than the day’s NAV, an investor can earn a higher return.
ETFs and Index Funds have varying trading volumes depending upon outstanding volume and investor interest. Liquidity for ETFs can be impacted.

Please also note that ETFs offer an advantage over Index Funds. An investor can leverage an opportunity to invest or not, at the preferred price, based on market movements during the day, unlike an Index Fund, where an investor can only enter the fund at the end of the day’s NAV.

Key takeaways

Here’s a comparison of the two investment products for easier understanding.

Aspect	Index Funds	ETFs
Investment approach	Invest in securities to match the benchmark index	Track stock market indices and trade like regular stocks on stock exchanges
Pricing	Priced at the closing of the trading day	Priced throughout the trading day
Transparency	Publish top 10 holdings mainly, less transparent	Publish underlying holdings daily, highly transparent
Expense fees	Costly for investors as higher management expense fees	Lower expense ratio but higher trading cost
Trading flexibility	Bought or sold at the end of the trading day’s NAV	Traded on exchanges like regular stock. Require a demat account
Risk level	More secure investment, long-term wealth creation	Relatively riskier form of investment

Both Index Funds and ETFs offer investors unique advantages and cater to different investment preferences. While index funds provide simplicity, stability, and cost-effectiveness for long-term investors, ETFs offer greater flexibility, intraday trading options, and potential for active management strategies.

From the sage
Warren Buffet believes that a passive form of investing is the best path to building wealth. Since cost matters, paying 1% for fees on the related modest returns can make an enormous difference in one’s retirement income.

Notes:

A Demat account is a depository account (or a custody account) where investors can hold their securities in digital form

Contributed by Priti Goel, Founder & CEO of Prisha Wealth Management Private Limited, and a certified investment advisor

Disclaimer – The above content is non-editorial, and TIL hereby disclaims any and all warranties, expressed or implied, relating to it, and does not guarantee, vouch for or necessarily endorse any of the content.

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