What’s better amongst an index ETF or an index mutual fund? Life would have been simple if answers to such questions were straightforward. In other words, every investor’s needs and expectations are different, and there is no one solution. As often said, one size does not fit all.
However, a comprehensive understanding of both these investment options will help you make the right decision. So, before we delve further, let us take a step back to refresh the concepts.
There are two investment strategies – active and passive. In the former, an investor decides which shares to buy, hold or sell. An understanding of the market and research of the company fundamentals backs this decision. Alternatively, investors subscribe to mutual funds, where professional money manager takes investment decisions. The basis of decision making is the same. Investing in a mutual fund is quasi passive form. The money manager takes the investment decisions instead of the investor.
Passive investment strategy entails replicating or following a benchmark. In other words, a money manager does not have to research a company. Instead, buy, hold or sell decisions on specific stocks is driven by the composition of the underlying index. For example, if Nifty 50 has a 10% weightage of Reliance Industries, the Nifty 50 Index Fund replicates the weightage in its holdings.
We have deliberated on active vs passing investing style in our previous note. Here we will go a bit deeper into passive investing, as both index mutual funds and ETFs are a part of the passive style. However, they are both still different from each other. So, let us get to learn more about index mutual funds and index ETFs.
What is an index fund?
Index funds, or index mutual funds, comprise a portfolio of shares that mimic a specific index, called the benchmark index. These funds track the benchmark index irrespective of market conditions. Therefore, the performance is usually stable and is suitable for long term investors.
These funds offer immense diversification. The objective of an index mutual fund is to match the performance of the benchmark it follows as closely as possible. Although, the index returns and index mutual fund returns can still be different due to tracking errors or other reasons. However, the lower the difference, the better the is mutual fund’s performance.
What is an exchange-traded fund (ETF)?
In an ETF, a portfolio mirroring the benchmark index gets created. First, it consists of the securities that form part of the benchmark index. After that, the ETF gets listed on the stock exchange. That allows investors to trade in the ETF like any other stock.
One can create an ETF from any asset class that has a published index. Bonds, real estate, commodities, currencies, and multi-asset funds are available in an ETF format. However, the asset class must be liquid enough to be traded daily. For instance, mutual funds in India offer Gold ETFs, where the underlying investment is in physical gold.
Refer to About the ETF on the Association of Mutual Funds in India (AMFI) website for more information.
Index mutual fund vs Index ETF – a comparison across parameters
Index mutual funds are a passive form of investment. However, some investors must have demanded greater sophistication within this style of investment. And then came the ETFs. In other words, ETF is an investment option for the passive but (yet) not so passive investors.
Here are a few specific points:
1. The DNA
Investments into an index fund accumulate as part of the Assets Under Management (AUM) of the mutual fund. The mutual fund then invests the assets as per their objective. Therefore, a new investment, or redemption, happens from the assets under management (AUM).
The ETFs are closed-ended and do not accept fresh infusion or redemption requests. ETF’s gets listed on a stock exchange. Therefore, any transaction requires a counterparty who would like to conduct an opposite trade, like any share trade. The ETF creates and redeems units in predefined lot sizes, called the creation unit. The AUM in ETF fluctuates based on the market value of shares held in the portfolio.
2. Investment mechanism
Index funds are suitable for a systematic investment plan (SIP). These funds are usually ideal for long-term strategy, and the most recommended format is to invest via a SIP. However, lumpsum investment is also a possibility.
ETFs are close-ended funds, and they are eligible only for a one-time investment at inception. After that, ETFs are available for investment as any other listed share.
3. Dividend re-investment
Dividend re-investment automatically happens in the case of the index funds growth option. On the other hand, ETFs dividend gets paid into the investor’s bank account.
4. Acquisition price
An index fund is a mutual fund. Therefore, a purchase or a redemption transaction happens at the NAV, as per the cut-off time. However, an ETF trade occurs on the stock exchanges where prices and transactions are real-time.
Therefore, investors cannot decide the cost of acquisition or redemption in a mutual fund. On the other hand, in ETFs, the investors can determine the price of entry and exit.
5. Need for Demat
ETF trades are subject to securities transactions and turnover tax, like shares. Therefore, ETFs require a Demat account, like for stocks. On the other hand, index funds, like mutual funds, do not need a Demat account.
6. Market-based trade
ETFs allow investors to take a position based on their projection of the market trend. Since ETFs behave like shares, investors can take a directional view and short-sell the ETFs. Therefore, ETFs are an excellent hedging vehicle. These trades do involve transaction costs but provide a great deal of flexibility. No such options are available in the case of index funds.
7. Flexibility of investing
Mutual funds follow clearly defined investment objectives. Those may restrict aggressive investments. For example, there could be restrictions on rapid share trading. In addition, the fund goals govern asset classes that the mutual funds can hold.
On the other hand, ETFs are meant for speed as there are no such restrictions and are therefore considered agile. In addition, ETFs can invest in money market instruments to maintain liquidity.
8. Capital gains
Trades in ETF result in transaction charges and capital gains based on purchase and sale price.
In the case of mutual funds, capital gains occur on two accounts. First is when the investor sells the mutual fund held in the account. Second, when the mutual fund sells its holding, the fund incurs capital gains tax, ultimately borne by the investors.
9. Expense ratio
The total expense ratio (TER) of ETFs is lower than the index funds. TER is a measure of expenses incurred to run the fund and includes operational costs like management fees, compliance costs, distribution charges, etc.
ETF or Index Fund – which is the right one for you?
In conclusion, the best strategy is to take advantage of both the investing options. ETFs provide greater flexibility but incur higher transaction costs. On the other hand, index funds are simple as there are no trading decisions, but the expense ratios can be higher.
ETFs are like stocks, of the bucket of shares forming benchmark indexes like Nifty50 or BSE Sensex. Stock exchanges list ETFs; therefore, investors get an opportunity to take advantage and trade in them.
Index funds mirror an underlying index, but there is no opportunity to trade. Therefore, investing in an index fund is purely passive.
Investors can position index funds as the core of their portfolios. Invest in ETFs to diversify and build aggressive positions within the passive investment framework.
We stick to our opinion – that there is no definitive answer. Instead, investors should decide the most suitable option based on their preferences and investment objectives. In case of any doubts, do consult your financial advisor and seek proper guidance.
About the author
The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. Through his writing, the author wants to share his knowledge and understanding of the subject.
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Disclaimer
The author has used his knowledge, experience, and understanding of the subject and has exercised extreme caution to avoid possible mistakes. However, the author does not take any responsibility for any error that exists.
Any views, opinions, and thoughts mentioned in the article belong solely to the author and not necessarily to the author’s employer (past or current), organization, committee, or other group or individual.
Under any circumstances, the author shall not be liable for any views or analysis expressed in this note. Further, the opinions expressed are not binding on any authority or Court. We advise readers to consult their financial advisor for assistance in their specific case.
