Differences between ETFs and index funds: Which one to choose?

ETFs and index funds are popular passive investment vehicles. Both pool money from investors and invest the amount in securities to track and match certain market indices. But how does one choose between ETFs and index funds, and which is the better option? 

Well, there is no straight answer to this question. A lot of factors need to be considered, such as costs, returns, etc. While the two may seem to have a lot in common, they are quite different in reality. This article will discuss the merits of ETF vs index funds and examine how safe they are.

What are ETFs, and how do they work?

ETFs, or exchange-traded funds, are a kind of security that tracks an index, commodity, sector, or another asset. They can be bought and sold in the same way as regular stocks. You can think of ETFs as a basket of securities that pools funds from various people and utilises them to buy tradable monetary assets. The working of ETFs is like both mutual funds and shares. 

ETFs can be found on all major stock exchanges and are traded during the equity trading time. The share price of ETFs is derived from the cost of the underlying assets. The value of dividends earned by the shareholders depends on the performance and asset management of the ETF company.

Related: ETFs: 6 Reasons They Make An Excellent Instrument For Investors

What are the different types of ETFs available in India?

There are primarily four kinds of ETFs in India: Equity, Debt, Gold, and Currency. 

1. Equity ETF: These invest in shares and other equity options across various organisations.
2. Debt ETF: When enterprises trade in fixed return securities, such as government bonds and debentures, it’s called debt ETF.
3. Gold ETF: These are commodity exchange-traded funds, typically involving physical gold. When you buy these funds, you own gold on paper. This eliminates the burden of protecting the asset.
4. Currency ETF: This involves the purchase of different currencies based on predictions and calculations. They derive profits due to the fluctuation of exchange rates.

What are index funds, and how do they work?

Index funds or mutual funds invest in stocks that emulate a stock market index, such as the BSE Senses, NSE Nifty, etc. These funds are managed passively, and the fund manager invests exactly like the underlying index and in the same proportion to imitate the portfolio composition. 

Index funds are aimed at providing similar returns as the index they track. Since they track the indices exactly, they can include equity and equity-related instruments and bonds.

What are the different types of index funds available in India?

Broadly, there are five kinds of index funds available in India.

• Broad market: Such funds are ideal for investors who want to invest in a variety of financial instruments. A broad market index aims at capturing a broad section of the market. These funds usually have the lowest expense ratios.
• Market Cap-based: Index funds that focus on market capitalisation get maximum exposure to a mixed bag of small- and medium-sized enterprises.
• Earnings-based: Certain index funds work based on the earnings of a company. A company has two kinds of indices - value indices and growth indices.
• Bond-based: Bond index funds enable you to maintain a balance of short, intermediate, and long-term bonds that generate stable revenues.
• International: These offer you global exposure. By investing in such funds, you do not get restricted to a particular region.

Related: Is It Time To Move From Active Funds To Index Funds In India?

What are the differences between ETFs and index funds?

ETFs and index funds have several similarities but work on different approaches. While they are both passive investment vehicles, there are some significant differences between ETFs and index funds. Here's how ETFs and index funds differ across various parameters:

1. Objective: The main aim of ETFs is to track the performance of specific indices of an exchange. Index funds, on the other hand, replicate the performance of the underlying index as is.
2. Trading: While index funds are issued in units like other mutual funds, ETFs are traded much like stocks on a stock exchange.
3. Pricing: The pricing of ETFs follows the same principle as shares. In contrast, the Net Asset Value (NAV) of index funds varies due to multiple factors.
4. Influencing factors: In the case of ETFs, the demand and supply of securities affect the price. In the case of index funds, the NAV of the fund and the underlying assets impact the price.
5. Cost: A transactional fee is applicable when you invest in ETFs, while index funds do not have any transactional fees.
6. Expense Ratio: The expense ratio is low in the case of ETFs and high for index funds.

How to choose between ETFs and index funds?

Since ETFs and index funds are similar, you might have trouble picking the right passive investment vehicle for you. In the end, the decision boils down to one’s trading style. ETFs, much like stocks, trade intraday. They are a good choice if you want to take advantage of price movements within the day.

Index funds will be a better option if you are not concerned about seizing intraday opportunities. Moreover, while you need to be well-versed with the trading process if you want to trade ETFs, that is not necessary with index funds.

Related: Different Types Of Funds Available Under Mutual Funds

Last words

ETFs and index funds, despite their similarities, are quite different. While ETFs track stock market indices, index funds imitate them in exact proportions. Before choosing one over the other, determine which of the two trading styles aligns best with your goals. Also, consider the amount you are willing to invest and the additional charges incurred along the way.

In the end, it does not have to be a choice. If you find both ETFs and index funds aligning with your financial goals, you can invest in both.