Exchanged Traded Funds (ETFs) and index funds are low-cost ways to build a diversified equity portfolio.
Both are passive investments. Both try to replicate (and not beat) the performance of a benchmark index. For instance, both Nifty 50 ETF and Nifty 50 index fund will try to replicate the performance of an index fund.
This is achieved by holding the constituents in the same proportion as in the benchmark index. Thus, if Nifty 50 has 15% Reliance Industries and 10% HDFC Bank, the Nifty ETF and the Nifty 50 index fund portfolio will also have 15% Reliance and 10% HDFC Bank. No discretion.
Expectedly, the returns from an ETF and an index fund (on the same benchmark) will also be along similar lines.
What is the difference, then, between the ETFs and the index funds? Which is better: An ETF or an index fund? Where should you invest?
In this post, let us find out.
Read: What are Exchange Traded Funds (ETFs)?
#1 Index Funds vs ETFs: Buy and Sell (Transaction Ease)
A fundamental difference here.
You buy index funds from the Asset management companies (AMCs or mutual fund houses). You sell index fund to an AMC.
You buy ETFs from a fellow trader. You sell to a trader. Buying/selling ETF is just like buying/selling a stock.
If you are big investor, you can directly buy ETF creation unit from the AMC. For instance, you can buy Nifty ETF directly from ICICI Prudential for ~ Rs 80 lacs (as on May 17, 2021)
#2 Index Funds vs ETFs: Liquidity
For index funds, since you buy and sell from AMCs, liquidity is not a problem. The AMC must ensure liquidity.
In case of ETFs, since you buy and sell from other investors/traders, liquidity can be a concern.
If you want to buy, you need a find a seller.
If you want to sell, you need to find a buyer.
While we may believe that ETFs with larger AUM may be more liquid, that may not always be the case. The ETF liquidity is a function of liquidity in underlying securities and level of market-making in the ETF. For more on ETF liquidity, refer to this paper.
#3 You can buy/sell ETFs throughout the day
Advantage ETFs.
Markets fall suddenly in the morning. You think this fall is temporary and markets will bounce back within a few hours. Let us say Nifty opens at 15,000, goes down to 14,500 and but bounces back and closes the day at 15,000.
Can you take advantage of such intraday fall in the market?
Not with index funds.
You can buy and sell index funds ONLY at the day-end NAV (linked to day-end index level). Thus, there is no way you can take advantage of intraday volatility through index funds.
Yes with ETFs.
However, with ETFs, you can buy/sell throughout the day, just like stocks. Thus, you can take advantage of intraday volatility through ETFs.
Whether such intraday trading is useful or not is a different matter, but ETFs do afford you that flexibility. Index funds do not.
#4 ETFs have no concept of Regular or Direct
Index funds will come in both direct and regular variants. You save on commissions if you invest in direct plans of index funds.
No such concept with ETFs.
You buy ETFs on exchanges and that’s it.
ValueResearch website shows ETFs under REGULAR section and that can be misleading. No commission paid to anyone when you buy ETFs. It is just like stocks, where you pay brokerage (and not commissions).
#5 ETF vs. Index Funds: Transaction costs
Advantage Index funds.
When you buy mutual funds, you do not incur any transaction cost (except stamp duty).
No transaction costs while selling either (except STT).
In case of ETFs, since you must buy and sell on the stock exchanges, you must incur regular trading costs such as brokerage etc.
If you are working with a traditional broker or a full-service broker such as ICICIDirect, these charges can be huge.
If you are buying ETFs over index fund purely because of costs, such transaction costs can wipe off years of savings upfront.
Let us say Nifty 50 ETFs has an expense ratio of 0.1% (10 bps). A Nifty index fund has an expense ratio of 0.15% (15 bps). You decide to go with ETF since the expense ratio is 5 bps lower.
Now, if you must pay a brokerage (plus other charges & GST) of 50 bps upfront to buy the ETFs, you have paid 10 years of cost savings upfront. You save 5 bps (0.05%) by investing in ETFs. However, for such savings, you pay 50 bps upfront. Not much sense, right?
You will incur the same level of transaction costs when you sell.
Therefore, keep this aspect in mind.
If you are working with a discount broker such as Zerodha, brokerage will not be much of a problem.
#6 ETFs vs Index Funds: Expense Ratio and Tracking Error
ETFs tend to have lower expense ratios than index funds.
I copy the following data about HDFC and SBI ETFs and index funds from ValueResearch website.
In the above, you will see “ETF” somewhere in the names of ETF schemes. The expense ratios are lower than index funds. The difference is even wider if you compare expense ratio of ETF with expense ratio of regular plans of index funds.
However, there is no such rule that expense ratios of ETFs must be lower than those of index funds. Usually, AMCs charge whatever they can get away with.
From the perspective of AMC, ETFs are easier to manage compared to index funds. With index funds, the AMC needs to manage inflows into the scheme and outflows from the scheme. The AMC must provide unlimited liquidity to the investors (the investors can redeem anytime).
No such problem with ETFs. Once the ETF units are issued to the AMC, buying and selling is your headache. You need to find buyers and sellers on the exchange. The AMC is not bothered. They just need to rebalance the underlying portfolio when the benchmark index changes and manage dividends from underlying stocks (this happens in index funds too).
This explains the lower expense ratio of ETFs to some extent. Moreover, for the reasons mentioned above, it is likely that ETFs will have lower tracking error than index funds.
By the way, we do not have just Nifty 50 or Nifty Next 50 ETFs. There are ETFs on other indices too. On such indices, AMCs charge a much higher expense ratio (than showed in the above illustration).
#7 Price and NAV
What is NAV (Net Asset Value)?
In case of mutual funds (including ETFs and index fund), NAV is simply the value of the underlying assets divided by the number of shares/units issued.
Let us say a mutual fund scheme holds 1000 shares of Stock A and 1000 shares of Stock B. At the end of the day, the last traded price of Stock A is 100 and stock B is 50. No other asset in the portfolio.
Total value of the portfolio = No. of shares of A * Last traded price of A + No. of shares of B * Last traded price of stock B
1000 * 100 + 1000 * 50 = Rs 1.5 lacs
Now, let us say the AMC has issued 10,000 units of the MF scheme.
In that case, NAV of the scheme = 1.5 lacs/ 10,000 = 15.
You can buy and sell index funds only at day-end NAV. And that is the price of the index fund unit.
However, you can buy and sell ETFs through the day. And the price (at which you buy/sell) can be different from the NAV.
Moreover, the market price of Stocks A and B will fluctuate throughout the day. As the price of underlying stocks fluctuate, the NAV of the ETF will also fluctuate.
Ideally, you would want to buy or sell as close to the ETF NAV. And thus, would want to place your buy-or-sell bid at the real time NAV (and not at the closing NAV of the previous day)
However, how do you figure out what is the real-time NAV of the ETFs? Fortunately, AMCs release such real-time NAV on a regular basis. You can check real time NAVs on respective AMC websites. Nippon India AMC, ICICI Prudential AMC.
I checked the Real-time NAV of Nippon India Junior Bees (Nifty Next 50 ETF) and bid/ask quotes on NSE.
At the time, the real-time NAV was 377.78. So, if you are a buyer, you would not want to buy for more than the real time NAV.
However, even the best bid is higher the real time NAV. Not good.
Sometimes, the gap between the price and the NAV can be much wider.
If you want to invest in ETFs, do consider this aspect while choosing the ETF.
Index Funds vs ETFs: What should you choose?
In my opinion, ETF is a superior product than index funds.
However, buying/selling ETFs is a challenge, at least for now.
To invest in ETFs, you need a demat account. You must understand the difference between the Price and NAV. You must try to buy as close to the real-time NAV as possible. Work with a low-cost broker. You need some trading skills.
You cannot run a SIP in ETFs. Thus, difficult to automate investments. Some brokers may allow a similar set up through market orders, but market orders can be a risk in ETFs with low liquidity, higher bid-ask spreads and wide difference between price and NAV.
A few AMCs have launched Fund-of-Fund schemes (FoF) that invest in the ETF. For instance, ICICI Prudential launched a Low Volatility FoF that invests in Low Volatility ETF. With FoFs, you do not have to worry buying/selling the underlying ETF. The AMC would manage that. Makes it easier for investors. You do not have to worry about liquidity. You can also run a SIP.
However, you must understand that there is double incidence of cost in the FoF structure. The cost of FoF and the cost of underlying ETF. Would have been better if the AMC had simply launched an index fund.
For now, despite various advantages of ETFs, I will stick with index funds (or even FoFs in some cases) because of transaction and execution ease. My opinion may change in the future.
And yes, when I say I prefer index funds over ETFs for now, I mean Direct plans of index funds (and not regular plans).