Investment Method Comparison: ETF versus Index Fund - Their Meaning and Ideal Investment Opportunities
When it comes to investing in the Indian stock market, two popular options for passive investing are Exchange-Traded Funds (ETFs) and index funds. Both have their unique features and benefits, making the choice between the two crucial. Here's a breakdown of the key factors to consider when choosing between ETFs and index funds in India.
Expense Ratio
One of the significant differences between ETFs and index funds lies in their expense ratios. ETFs generally have lower expense ratios due to their structure compared to index mutual funds, which have overhead costs that slightly increase their fees.
Trading Flexibility
ETFs trade like stocks on exchanges throughout the trading day with real-time pricing, allowing intraday buying and selling. In contrast, index mutual funds are bought or sold only once per day at the Net Asset Value (NAV).
Minimum Investment
Index funds usually have a fixed minimum investment amount or Systematic Investment Plan (SIP) amount (often starting around ₹500), while ETFs require purchasing at least one unit, which could be the market price of one share.
Tax Efficiency
ETFs tend to be more tax-efficient with typically lower capital gains tax incidence compared to index mutual funds.
Account Requirements
Investing in ETFs requires a Demat and trading account since they trade on stock exchanges. Index mutual funds can be bought directly through fund houses without needing a Demat account.
Tracking Error
Consider the tracking error—the difference between the fund's returns and the index it tracks. Both ETFs and index funds tend to have low tracking errors, but individual fund performance can vary.
Liquidity and Pricing Transparency
ETFs provide better liquidity and price transparency due to continuous trading on exchanges. Index funds are priced once a day at NAV, which might offer less flexibility for timing investments.
Suitability for Investors
ETFs suit investors who want intraday trading, price flexibility, and tax-efficiency, and are comfortable with a Demat account. Index funds suit investors preferring a simpler, hands-off approach with systematic investment plans (SIPs) and no need for trading accounts.
Liquidity and its Impact on ETFs
The liquidity of the Nifty 50 ETFs varies widely, with some ETFs having very low volumes. The less liquidity an ETF has, the more the gap between the price and the NAV of the ETF could be. SEBI has instructed fund houses to publish iNAV or intraday NAV for ETFs, which can tell you the actual worth of one unit of an ETF.
Performance Comparison
In 2022, nearly 67% of active large-cap funds underperformed the Nifty 100, 55% of active mid-cap funds underperformed the Nifty Midcap 150, and even though just 13% of small-cap funds didn't beat the benchmark, this number was quite high in the preceding two years. Against an average 5-year return of 13.53% from Nifty 50 ETFs, Nifty 50 index funds delivered 13.23%.
Price-to-NAV Gap and its Influence on ETF Returns
The price-to-NAV gap and liquidity are important determinants for ETF returns. The price of an ETF can deviate from its NAV due to demand and supply, and low liquidity can affect the ease of buying and selling ETFs. If the ETF price is higher than its NAV, you are paying more than what the ETF is worth. Conversely, if the ETF price is lower than its NAV, you are getting the ETF cheaper.
Expense Ratio and Trading Costs
When comparing the expense ratio, ETFs have an average of 0.07%, while index funds have an average of 0.22%. However, there are trading costs associated with ETF investing that should be considered.
Tracking Error and its Impact on ETFs
ETFs have a lower tracking error on average, which suggests that they do a better job of tracking the Nifty 50 index. This is due to the fact that ETFs have no requirement to manage inflows and outflows, unlike index funds.
Trends in Passive Funds
The assets of passive funds, including ETFs, index funds, and funds of funds, grew from Rs 1.22 lakh crore at the end of 2018 to 6.36 lakh crore by 2022-end, representing a jump of over 400% in just 5 years.
In conclusion, the decision between ETFs and index funds depends on your investment goals, trading preferences, account setup, tax considerations, and cost sensitivity. If you want low cost, intraday trading, and tax efficiency and have a Demat account, ETFs may be preferable. For investors seeking simplicity, systematic investing without trading accounts, and flexibility in small periodic investments, index mutual funds might be more appropriate.
Mutual funds, particularly index funds and ETFs, are widely used in personal finance and the field of finance for passive investing. ETFs, with lower expense ratios and better trading flexibility compared to index mutual funds, may suit investors who prefer intraday trading, price flexibility, and tax efficiency, while also having a Demat account. In contrast, index mutual funds, with fixed minimum investment amounts or Systematic Investment Plans and no need for trading accounts, might be more attractive to investors seeking simplicity and systematic investing.
