You might have heard of the two terms Index Fund and ETF before, but you may not be aware of their obscure features. Your investment portfolio is incomplete without them. Inclusion of Index Fund or/and ETF in the investment portfolio provides the required diversification and helps in long term wealth creation . Hence, they form an essential part of every good investment portfolio.
We often get queries from our readers, which one to choose between the two. On the face, Index Funds and ETF may look like twins, but in reality they are different and have different finger prints. Here we will try to explain both the financial products, and will help you to decide, which one to choose for yourself.
What is an Index Fund?
In simple terms, Index Fund is a category of Mutual Funds, whose portfolio is similar to that of a stock market index. The stock market index can be any; Nifty50, BSE Sensex, Nifty 100, etc. For example, HDFC Index Fund- Sensex, consists of all the 30 stocks which are part of the BSE Sensex, and in the same proportion. For instance, if Reliance Industries has 18.5% weight-age in Sensex, then the HDFC Index Fund-Sensex, will also try to invest 18.5% of their total Asset Under Management in Reliance Industries. Hence, one can infer that the return generated by HDFC Index Fund-Sensex will be very similar to that of the BSE Sensex.
Index fund is a passive investment fund, i.e. its target is to achieve same return of that of the benchmark. The fund manager doesn’t have to scratch his head over investment strategies and stock picking, all he has to do is replicate the portfolio of the fund with that of the chosen Index. Hence, expense ratio (fund management charges) for these type of funds is very low.
What is an ETF?
ETF or Exchange Traded Funds, as the name suggests are funds that are traded on exchange, (i.e. listed on a stock exchange) and comprises of equity, bonds, or metals or a combination thereof. Generally, Equity ETFs are passive funds and mimic a stock market index, similar to that of an Index Fund. However, unlike Index Funds, ETFs are listed on exchange. The price of an ETF on the exchange is almost similar to its net asset value (NAV). For example: SBI ETF – Nifty 50, tracks the Nifty50 in a homogeneous manner. Return on SBI ETF -NIfty 50, is almost similar to the performance of Nifty 50.
One can buy ETF on the stock exchange just like any other stock. Hence, by buying just one unit of SBI ETF – NIfty50, one can get exposure to the entire 50 stocks of Nifty 50. It is as simple as it looks.
Now, after reading about both, you might be confused, which one is better. Don’t worry, we have juts the correct solution for your confusion. Which is better Index Fund or ETF?
Systematic Investment Plan (SIP): If you are a SIP lover and need a reminder every month to invest or save, you should go with Index Fund. An Index Fund gives you the SIP option. However, the same option is not available in ETF, as ETF is not a mutual fund scheme and trades on the exchange like any other stock.
Expense Ratio: Expense ratio is the annual cost paid to fund manager by investors for management of the fund. Although expense ratio of Index Fund is low, but in comparison to ETF, it is higher. For instance, expense ratio of Index Funds typically range between 0.15% to 0.50%, whereas for ETFs, it is usually between 0.05% to 0.20%. So, why would you give the Index Fund manager higher fees for just replicating the Nifty50. It is because of the convenience offered by Index Fund.
Convenience: Once you start a SIP in Index Fund, the entire headache is now with the fund manager. Your money will be automatically invested in the Fund, every month. You don’t have to do any transaction by yourself. However, in ETF, you have to place order for the ETF through your DEMAT/Trading account, which may be little difficult for a newbie. When to place the order, how to place, at what price to place the bid, etc. So, if you are a complete newbie and want the convenience of the Index Fund, you can incur higher expense ratio and invest in Index Fund, to get a peaceful sleep.
Expenses: While investing in ETF, you will have to incur brokerages and demat account charges, which is not there in case of Index Fund. All in all, if the amount being invested in ETF is large and you invest lump sum in ETF once in a while, then brokerage charges will be lower compared to the expense ratio incurred in Index Funds.
Control: ETF offers you complete flexibility and control over your investment. You can invest in ETF on any trading day at any trading time, which is not feasible in Index Fund. Net Asset Value of an Index Fund is only available at the end of the day, while for ETF it is available throughout the day. If you have fair market knowledge and you are sure of your timings, you can go for ETF, as that will allow you to invest your money, when the markets are down and sell your investment when markets are high.
Dividends: In case of Index Funds you have an option to choose, that whether you want the dividends from portfolio stocks to get reinvested or receive the same in cash in your bank account. As a long term investor it is always advisable to go for reinvestment option. There is no reinvestment option in case of ETF, you are forced to receive dividends in your bank account. If you want to reinvest dividends in ETF, then you will have to manually investment the dividend money in ETF by yourself.
Tracking Error: Tracking error measures the deviation of the fund from its benchmark. Since both Index Funds and ETFs replicate their respective benchmarks, tracking error in case of both is low. Nevertheless, tracking error is little higher in Index Funds compared to ETF, as the index fund manager has to keep some amount in liquid funds for unit redemption, which is not the case with ETF. If you want exact return like the benchmark, then ETF is more suitable financial product for you.
Tax Implication: Tax on Index Fund is charged at the time of redemption of units. You will incur Capital Gains tax for your Index Fund. If Index Fund units are sold before 12 months, the Short Term Capital Gains Tax of 15% will be applicable. While, if they are sold after 12 months, the Long Term Capital Gains Tax of 10% will be charged, over ₹1 lakh of capital gains. Equity ETFs are taxable in the same manner as the Index Fund. You may also be taxed on the dividends received from ETF.
Overall, merits and demerits of Index Funds and ETFs are quite balanced. Nonetheless, Index Fund is suitable for new investors who are not active in markets, lack investment discipline and desire convenient investing experience. On the contrary, knowledgeable folks, with fair bit of stock market experience and having the desire for control and flexibility over their investments should go for ETFs.
Thanks for reading! Hope this will help you in your investment journey!
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