In my earlier article, I had explained how passive investment is gaining ground among mutual fund investors. Passive funds provide a low-cost investment offering for investors looking to earn decent returns from equities by tracking the respective benchmark index and/or underlying fund. It is especially suitable for investors who do not have the appetite for high volatility and those who find it difficult to choose the right fund from the available actively managed funds.

To achieve its target, passive funds invest in the same basket of securities that form part of the underlying index and in the same proportion. Exchange Traded Funds (ETFs) and Index funds are the most popular approaches followed by mutual fund houses.

Though ETFs and index funds are similar in many ways, there are certain factors that distinguish the two.

The question that arises here is,

Which is the better of the two?

And more importantly,

Which is the more suitable option for you?

So read on to know the difference between these two funds:

1) Structure/Nature

Index funds, as the name suggests, aim to mimic the performance of particular index such as Nifty 50, S&P BSE Sensex, S&P BSE 500, etc. Following a passive investment strategy, these funds try to match constituents that form part of the index with an aim to mirror its performance. Therefore, when you invest in an index fund, the scheme’s performance will mimic that of the index.

Similarly, ETFs invest in a basket of securities that form part of an index. ETFs aim to track and replicate the performance of the relevant index. However, unlike index funds, ETFs are traded on stock exchanges. In simpler terms, ETFs are index funds that are traded on the stock exchange.

2) Transaction

Index funds can be purchased just like any other mutual fund, i.e. directly through the AMC or via mutual fund distributor. The NAV of the fund is declared at the end of the day; any purchase or redemption will be carried out at the closing value. Moreover, you can purchase index funds through SIP or lump sum mode.

On the other hand, to transact in ETFs, you will need a DEMAT account and a share trading account since they are traded on exchanges similar to stocks. The prices of ETFs fluctuate throughout the trading session as per the demand and units can be purchased and sold (intra-day trading is possible) at the prevailing real-time NAV. At the end of the day, you will get the closing NAV of the ETF. However, the option to opt for the SIP mode of investment, a disciplined approach to wealth creation, is unavailable in case of ETFs.

​3) Expense ratio and charges involved

Generally, the expense ratio of an index fund is slightly higher than that of ETF, though it is lower than actively managed funds. The average expense ratio of ETFs is 0.19% as of May 2021 and 0.34% in case of index funds. However, it is important to determine the total cost of ownership when you invest in ETFs, which can include additional expenses such as, annual charges for trading account, brokerage on transaction, etc. Therefore, the lower expense ratio of ETFs compared to index fund may not result insignificant benefit in the long run.

It is important to note that the exit load could be applicable if you redeem the investment within a specified period.

4) Liquidity

When it comes to transaction in index funds, it is the responsibility of the mutual fund house to allocate units for purchase transaction and to honour redemption requests. Thus, liquidity is not an issue in case of index funds.

For ETFs, demand is an important factor that determines the liquidity. Liquidity is usually higher for ETFs that track popular indices such as the Nifty 50 and S&P BSE Sensex, but lower in the case of other indices. Therefore, buying and selling units at a preferred price may not be as convenient for ETFs with lower liquidity.

5) Dividend treatment

When you invest in index funds, you have the option to opt for a growth plan or income distribution cum capital withdrawal plan (IDCW – erstwhile dividend plan). If you opt for the growth plan, the dividend (if any) is automatically reinvested in the scheme, whereas in case of IDCW, the NAV is adjusted to reflect the distribution of dividend.

In case of ETFs too, any dividend received by the fund is typically reinvested similar to the growth option of mutual funds even though it does not have a growth or IDCW option.

The reinvestment of dividend enables your wealth to appreciate in the long run through the power of compounding.

In conclusion

Both ETFs and index funds can help you earn decent returns in the long run; however, the latter can be a better option if you are looking for a convenient mode of investment. But ensure that you choose schemes carefully, taking note of the above-mentioned differences and its suitability to your investment objectives.

And when you invest in passively managed funds, prefer the one with low tracking error so that the performance of the fund does not deviate much from the index. By definition, the Tracking error is the deviation of a passive fund’s returns from its underlying index. Factors such as, cash balance held by the fund, the time lag in rebalancing/reshuffling of the portfolio in accordance with the index, dividend payouts, etc., can cause tracking error to rise.

Advisably, you should avoid sector-oriented passive funds if you do not have a very high risk appetite. For certain segments like mid-cap and small-cap, actively managed funds have better scope of generating high alpha in the long run.

Assess your risk appetite, financial objective, and investment horizon to determine whether to invest in an actively managed fund or passive fund, or a combination of both.

This article first appeared on PersonalFN here