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April 25, 2022

Best Investment option Index fund or ETF

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More than ever before Indian investors are taking a keen interest in passive investing and the financial industry is keeping pace with an ever-increasing bouquet of investment options now there are two ways by which passive investing is done in the equity markets you can either invest via a Mutual fund more specifically an Index Fund.

Alternatively, you can purchase an exchange-traded fund or ETF both these instruments essentially mirror an index like the nifty or the Sensex but your options need not be restricted to only the broader indices, for instance, today there are ETFs for gold commodities banks health care, CPSC Bharat 22.

Now, there is an increasing interest in factor-based ETFs like low volatility and value.

Also, International ETFs Index Funds and index ETFs have a lot in common including the fact that both products offer adequate diversification across tens hundreds, and even thousands of securities a low expense ratio, and of course potentially strong long-term returns.

So, in this blog, we shall pan our focus on understanding the differences between these two financial products and we will also look at the scenarios where one is better than the other.

With that being said let’s begin with the first key difference and if you like our blog then don’t forget to comment and subscribe to our website for more such updates and informative blogs on Investing.

Index Funds are passively managed instruments but that’s necessarily not the case with ETFs because ETFs can be passively managed or can be actively managed in fact as it stands about 20 percent of the ETFs in the US are actively managed which means there is an investment team that is researching companies and taking decisions on the ETF’s portfolio allocation.

These active ETFs can be innovative in the construct, for example, an ETF can be built to track what popular investors like Warren Buffett or Rakesh Jhunjhunwala are investing in by simply cloning their respective portfolios.

Another example of an innovative ETF can be something, what Kathy woods is doing with the ARC innovation ETF.

This ETF focuses entirely on disruptive innovation which includes investing in DNA technology firms, industrial innovators, health tech, and next-gen internet companies

So, remember while Index Funds are passive. ETFs are mostly passive but not all the time.

From an operational perspective, an Index Fund is a mutual fund while an ETF comes closer to how a stock works.

That’s because ETFs much like stocks can be traded throughout the day at a price that goes up and down whereas Index Funds can be bought and sold only at the price which is published at the end of each trading day.

Certainly not much of a concern for long-term investors but if you look to time the market then that’s where an ETF comes in handy with features like intraday trading stop losses order limits etc.

Of course, investing in an ETF requires you to have a trading and DMAT account while the purchase of an Index Fund is more straightforward and is most convenient when one uses the ET money/Coin by Zerodha/Groww app to track and invest in these Index Funds.

As a norm, ETFs are bought in units, so 1unit, 5units, 100units. While Index Funds are generally bought in terms of an amount. Like 500 rupees worth of Index Funds, 1000 rupees 10,000 rupees of Index Funds, etc.

This unit versus amount context has a bearing on the minimum investment one needs to put up when purchasing either of these two financial products, like in the case of ETFs most trading platforms allow their investors to buy even a single unit.

For instance, yesterday I bought one unit of the ICICI prudential Bharat 22, ETF which cost me about 40 rupees.

However, when buying some units in an Index Fund all mutual fund companies require a minimum order value of at least 100 rupees with some AMC starting even higher at ₹500 for SIP.

lumpsum transactions ETFs and Index Funds both come with low expense ratios but relatively ETFs tend to be cheaper than Index Funds in most scenarios.

For example, the HDFC nifty 50 ETF comes at an expense ratio of just 0.05 percent while the Index Fund variant that is the HDFC nifty 50 Index plan has an expense ratio of 0.20 for its direct variant that’s an extra 0.15 percent or if you choose to look at it differently that’s a 300 % premium over the ETF pricing.

Now the face of ETFs might seem cheaper than Index Funds and, in most scenarios, they are but there are two additional costs that ETF investors should be aware of.

The first of these additional costs are the commissions charged by a broker, that is the trading platform which is typically a percentage of the amount traded or a flat fee per transaction this commission or fees is generally a mix of many expenses like brokerage GST, STT, Stamp duty exchange fees, SEBI turnover tax, etc.

A second cost when trading in exchange-traded funds is the bid-ask spread which is a small transaction cost that is embedded in the price of the ETF. So, these are a couple of costs that do play their part in determining the final expense ratio of both instruments and something that all investors should be very off.

When you invest money in an Index Fund the asset management company simply adds your funds to its AUM and then go about its job of buying securities in line with the benchmark and since the exact opposite happens when you wish to redeem in effect with Index Funds, there is no real concern on the liquidity front.

However, when it comes to ETFs the lack of liquidity can certainly be a concern and that’s because unlike an Index Fund here the investor is buying the ETF like any other equity share so imagine a scenario where you want to sell 100 units of your ETF but there are no buyers for those units in that case you are trapped as you will not be able to sell any of your ETF units at the price at which you want to sell them and that’s the liquidity problem with ETFs.

Having said this the situation in India is certainly improving from a liquidity standpoint but this continues to be a problem, especially in some of the sectoral or smart beta ETFs.

Where the trading volumes are still on the lower end systematic investment plans or SIPS are a popular method of investing for retail investors with monthly inflows consistently crossing the 8,000-crore mark for many months now.

While Index Funds offer the SIP facility, ETFs generally do not offer any SIP option this is a serious handicap because the SIP route remains a very disciplined and steady way for investors to participate in the equity markets but more recently, we have seen a couple of platforms offering an ETF SIP facility but these are far and few.

Hopefully, more platforms will introduce this vital facility in the months to come.

So, if you’re one of those investors, who’s more comfortable with investing in equities using the SIP route then presently Index Funds might be the right way to go about it.

let’s do a quick recap, these were the six differences between ETFs and Index Funds,

  1. There are differences on account of the fund management style that is while most ETFs are passive some can be active as well.
  2. The trading style where ETFs operate a lot like stocks while Index Funds are mutual funds.
  3. The minimum investment amount in an ETF versus an Index Funds.
  4. The expense ratio.
  5. What more should one be considering with regards to ETFs the liquidity of the two instruments?
  6. SIPS which are more aligned to the Index Funds.

ETFs and Index Funds are quite similar and choosing one over the other will depend on what you seek as an investor and your investing behavior for instance if you are someone who is a long-term investor with long-term goals you would prefer a disciplined approach to investing which can best be provided by an Index Fund via the SIP facility.

However, if you are keen on trading when the markets are volatile then ETFs might serve as the more worthy tool several tactical investors, who have an above-average understanding of the stock markets tend to trade in ETFs for very short durations?

Especially if there has been some news-driven market tip in most cases these corrections are of three odd percent and are pretty temporary but it does not stop people from trying to take advantage of that in fact in the last 15 years there have been 93 such occasions when the nifty has closed the session with a loss of more than three percent.

With this, we come to the end of this blog, if you like this investing GYAN. Then don’t forget to like or comment below and share this with your friends.

Thank you for your time and I look forward to catching up with you soon with more investing ideas until then mutual fund investments are subject to market risks read all scheme-related documents carefully before investing.

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