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Index Fund vs. ETF: What’s the Difference? What is right for you?

Written by - Akshatha Sajumon

March 22, 2022 7 minutes

Any new investor would like the idea of investing his/her funds in a mutual fund since it is considered a safe investment option. The idea is to let a fund manager decide on the allocation of funds across various securities. There are also funds that are passively managed but can provide benefits that are similar to a mutual fund. 

Two examples of passive fund management are Index funds and ETFs. 

Passive management of funds should not be mistaken as zero involvement of fund managers. These do have fund managers, but, since the funds follow an index, there is no requirement of manual selection of securities by the fund manager.

Funds that follow passive investing aim to mirror the chosen index. For investors who are unaware of details about index funds and ETFs (Exchange-Traded Funds), it can be confusing to choose between the two. Here, we will discuss all the factors surrounding Index funds and ETFs to allow investors to make a wise investment decision and choose an ideal option as per their investment goals.

What are Index Funds?

  • Definition 

An index fund portfolio is designed to match the components of the chosen market index. For instance, the Nifty 50 Index. This fund type aims to offer broad market exposure to investors. It has a lower expense ratio and comparatively lower portfolio turnover. Irrespective of the market movements, these funds continue to follow the benchmark index.

  • Key features of index funds

It would be good to know about the key features of index funds before proceeding with the differences between index funds and ETFs.

  1. In an index fund, the fund manager’s job is to select securities as per the Index composition.
  2. Since it mirrors the Index, the fund performance will likely be similar to the returns generated by the Index.
  3. An index fund is a passive investment, and therefore, the costs are considerably low. This makes it a good investment option for investors.
  4. The risk involved in an Index Fund is similar to any market-related investment option, depending on the composition of the fund.
  5. Index fund investments can be easily liquidated since the AMC is bound to buy/sell mutual fund units.
  • Top Index Funds

Some of the top-performing index funds in the Indian market are:

  1. HDFC Index Nifty 50
  2. UTI Nifty Index Fund
  3. ICICI Prudential Nifty Next 50 Index Fund
  4. Motilal Oswal Nifty Next 50 Index Fund
  5. HDFC Index Sensex

What are ETFs?

  • Definition 

An Exchange Traded Fund (ETF) consists of a collection of securities that mostly follow an underlying index. These funds invest across industry sectors and may use various strategies. While ETFs are very similar to index funds, these are listed on exchanges. ETF shares can be traded throughout the day, just like any stock trading in the financial markets.

  • Key features

Let’s look at the key features of ETFs before proceeding ahead. 

  1. ETFs can be bought and sold during market hours.
  2. A lot of ETFs are indexed based and therefore, these have to publish their holdings on a daily basis
  3. It allows investors to place a variety of orders like limit orders, stop-loss orders, etc
  4. ETF investment can inculcate multiple investment strategies and gives investors the choice for their portfolio construction
  5. ETFs enjoy a smaller market of buyers and sellers and can be less liquid as compared to Index funds and other mutual funds.
  • Top ETFs

Some of the top-performing ETFs in the Indian market are:

  1. Motilal Oswal NASDAQ 100 ETF
  2. HDFC Sensex ETF
  3. SBI – ETF Sensex
  4. Edelweiss ETF – NQ30
  5. UTI Sensex Exchange Traded Fund

What are the differences between Index Funds and ETFs

Let’s understand the key differences between Index funds and ETFs.

DifferencesIndex FundsETFs
ObjectiveAn index fund is like a mutual fund scheme that replicates the performance of the chosen index. Tracks the performance of the chosen index
Demat AccountIndex fund investments do not require investors to have a Demat account.ETF investments can be made only through a Demat account.
Nature of FundsOpen-ended fund. Here, the investment is added to total assets under management.ETFs resemble close-ended mutual funds which are traded on the stock exchanges.
LiquidityIndex fund units can be sold as per individual preferences since these are open-ended. Thus, they offer higher liquidity.ETF units cannot be liquidated easily since these may a smaller market of buyers and sellers. Essentially, investors have to wait for a corresponding buyer/seller to transact in ETFs.
CostThese are less costly as compared to mutual funds. However, they have a higher expense ratio due to higher transaction fees or commission as compared to ETFs.Lower expense ratio due to lower transaction fees as compared to Index funds.
Mode of InvestingIndex funds allow SIP (systematic investment plan) mode of investment in the funds. Investors can begin investing a small portion of money in periodic intervals.ETFs do not allow SIP mode of investment. Monthly investments in ETFs may increase the total cost due to brokerage and Demat charges. Or investors may have to shell out a lump-sum amount while starting the investment.

Choosing Between Index Fund or ETF – Factors to Consider

Here are some additional factors which will help investors to pick between index funds and ETFs:

  • Which one is better for new investors – Between Index funds and ETF, the latter is an ideal choice for someone who is an active trader. ETF requires the usage of more advanced strategies while purchasing. For a novice investor, an Index fund may be a safer option to consider as they are more liquid and easier to invest in, especially one who is looking to mirror returns to an index.
  • Dividend Payouts  – With ETFs, the dividend gets credited to the investor’s bank account and this can be manually reinvested later. On the other hand, Index funds offer some amount of convenience since investors can opt for a growth plan which allows dividends to be directly reinvested.
  • Alternatives to Plain Vanilla Mutual Funds – Both Index funds and ETFs offer investment diversity as against investing in regular mutual fund options. The portfolio diversification comes through equity exposure which is mirrored to an index. Depending on specific financial goals and in the long run, both these can offer sustainable returns because they mirror the chosen index. 

End Note

Investors don’t necessarily have to pick either an Index fund or an ETF. Both these put together can also make for an ideal investment portfolio that offers diversification, the right amount of stock market exposure, and sustainable long-term returns. 

Frequently Asked Questions

Are index funds better than ETFs?
For a new investor who is risk averse, an Index fund is a better investment option as compared to an ETF since it primarily mirrors the stock composition of an index. Index funds also offer better liquidity as compared to ETFs due to the availability of a larger market of buyers and sellers.

What are the downsides of ETFs?
Some of the downsides of ETFs include:

  • Concentration in large-cap stocks
  • Involve risk of market fluctuations
  • Do not offer SIP mode of investment

Which is a safe option, ETF or Index funds?
Both index funds and ETFs come with some degree of risk factor. Therefore, investors must make a choice depending on their financial goals and comfortability with both options.

Which is the best Index fund option in India?
An index fund can be chosen depending on an investor’s risk profile and also the index which he/she is able to track regularly. Also, investors must choose an index fund that has a comparatively lower tracking error.

Which are the best ETF options?
While choosing an ETF investment option, look for its liquidity, expense ratio, and tracking error. Always ensure to align your investment choice with your goals to fetch appropriate returns in the long-run.

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