Index funds and exchange-traded funds (ETFs) are two very common ways of passive investment. They both have very similar portfolios but differ in the methodology of trading. The basic idea behind both is to mirror an index and give similar returns like Nifty50, Nifty 100, Sensex.
Index funds
Index funds are mostly suggested for investors with low-risk appetites and who are looking for long-term wealth creation. These are considered stable investment instruments that generate good returns.
ETF
While ETFs also consist of shares that mirror an index, the units of an ETF are traded like any stock on the exchanges. If an ETF is of a particular index, then it would contain the same stocks as that of the index and the weightage will also be the same. Also unlike index funds, ETFs do not only track indices but also commodities, specific sectors.
There are many different kinds of ETFs available in India, from gold ETFs to index ETFs, Bharat 22 ETF which focuses on PSU firms.
Here's how they differ:
- The units of an ETF are traded on the exchanges and can be bought and sold like any other stock. The same is not true for index funds.
- One must have a Demat account to trade in ETFs, while people who want to invest in index funds do not need one
- ETF investments have a very low expense ratio of about 0.35 percent while the expense ratio of index funds is between 1-1.8 percent. Also, for an investment of every ₹10,000, a transaction fee of ₹100 is charged in an index fund.
- Also, an investor may be subjected to exit load at the time of redemption from the mutual funds, but no such cost is levied on ETFs.
- To invest in a mutual fund, you can start with a SIP of as low as ₹500 or a minimum lump sum investment of ₹5,000. Meanwhile, the minimum investment amount for an ETF is ₹10,000 and they do not have an option to invest via SIP.
- An index fund unit can only be bought or sold by the end of the day after the market settles. While an ETF can be bought and sold even during market hours like stocks.
- In the case of ETFs, the dividend is directly credited into the bank account and will have to be manually reinvested if needed. While in index funds, you can directly reinvest the dividend if you opt for the growth option.
- On the taxation front, they both are taxed at the same LTCG and STCG rates.