scorecardresearchETFs vs Index Funds: Know the key differences before you invest

ETFs vs Index Funds: Know the key differences before you invest

Updated: 09 Aug 2022, 03:34 PM IST

So many people inquire about ETFs and index funds and the difference between the two. While both are passive investments, there are many factors that you must consider before choosing to park your money in any one of them or both.

Growing money through ETFs and index funds

Growing money through ETFs and index funds

Given how many stock prices have rolled into a somersault during the past few months, many investors have moved to passive investing which allows their money to grow in sync with the market. One way can be to park money in exchange-traded funds (ETFs) with passive mutual funds being the alternative investment avenue. 

ETFs are just like stocks, which means that they track an underlying index that could be the Sensex or the Nifty 50. Since ETFs invest in a fixed set of stocks listed in that particular index, it is also called passive investing. This investment option suits best those who like to sit and see their investments grow sans any external interference.

Index funds also act to invest your money in a particular index that it follows, which explains their affinity among passive investors.

If both index funds and ETFs attempt to closely track a benchmark like the S&P 500, then why invest in one and not the other? What difference does it make whether you invest in ETFs or passive mutual funds? To start with, the key difference is that ETFs can be bought and sold on the exchange like stocks, unlike mutual funds. However, before you rush to any conclusion, let us understand their features that will help underscore their pros and cons too.

The price factor

There is no way that you want to invest your money and have no clue how much you would have to pay toward the investments. Since ETFs trade just like stocks on a stock exchange, you can simply log in to your demat account and check the real-time prices on the exchanges. Just like stock prices, ETF prices are also subject to fluctuations depending on myriad factors. This is why you can view their prices during trading hours. Index funds are passive mutual funds where you learn about their prices, which is the Net Asset Value (NAV) only once during the day.

Not that ETFs are bereft of NAVs. They have NAVs too that must move in sync with their prices. However, a mismatch between demand and supply causes ETFs to trade either at a premium or at a discount. That's why some ETF prices differ from their NAVs. That is not however the case with index funds where you are ensured units depending on their NAVs during the day.

The liquidity factor

You obviously would like to redeem your investments someday, and that is why you must be cognizant of how quickly they can be liquidated when needed. Some ETFs are more liquid than others. The liquidity of any ETF depends on how much it is in demand and the volume of transactions that take place in it every day. 

More in-demand ETFs are typically more liquid than others. A lot depends on the underlying index too. ETFs tracking major indices including the Nifty 50 Index and the Senses can be easily redeemed over those tracking niche indices tracking some particular sectors alone.

The liquidity factor in index funds is just like any other regular mutual fund, wherein you had been allotted units at the prevailing NAV during the purchase. The procedure remains the same during the sale as the investors can seek redemption of the units at the prevailing NAV then.

How much does it cost?

Valuations of any investment you make matter, and that is why you must be aware of the pricing mechanism. This will help you gauge the actual cost of the investments made. Investors parking their money in ETFs have to shell out much less compared to what they spend on investing in index funds. However, you must compare the costs of both given how the Securities and Exchange Board of India (SEBI) capped the expense ratios in many mutual funds in 2021.

Ease of investment

Investing in index funds is just like any other mutual fund. All you have to do is to choose the index fund you want to invest in and invest your earnings either online or offline through one of the designated point-of-purchases.

Investing in ETFs, however, necessitates you to have a demat account and a trading account. This means that if you are new to the world of investments, you cannot rush to invest in ETFs without having opened these two accounts that allow you to hold and trade securities in an electronic format. 

There are at least four types of charges levied on the demat accounts. They are the account opening charges, the annual maintenance charges for the demat account, the custodian fees and the transaction fees. These charges seem minimal if you are already investing in stocks and shares. However, if you are opening a demat and trading account solely to invest in ETFs, the annual maintenance charges linked to these accounts may seem like an additional expense eating into your profits.

Many people are averse to putting their money in ETFs owing to the hassle of opening and maintaining their demat accounts. They can then choose to park money in a fund of funds (FoF) with underlying investments in ETFs. These funds are just like other index funds, which means that you are saved from the rigmarole of opening a Demat account and a trading account. However, you must check for the expense ratio of the FoFs as they are subject to dual expenses – one for the FoF and another for the underlying fund.

Choosing your investments

Both kinds of investments have their pros and cons, respectively. Ultimately, it boils down to your financial goals, investment tenure and risk appetite. How much corpus you are looking forward to in future and where you want to park your money are the deciding factors in all kinds of investments, be it mutual funds or ETFs.

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First Published: 09 Aug 2022, 03:34 PM IST