ETF vs Index Funds – An Exchange traded fund (ETF) is an investment fund operating on the stock exchange holding assets such as stocks, bonds or commodities. These funds track a specific index and accordingly will design its basket of securities. They offer the benefit due to their low costs, tax-efficiency and features similar to a trading stock.
An index fund, on the other hand, is a mutual fund or an ETF constructed to follow a specific industry or index such as the S&P 500. It may design the portfolio based on the implementation rules such as:
- Tax management
- Tracking minimisation of errors
- Large block-trading
- Rules which screen social and sustainable criteria’s.
In this article, we look at the key differences between ETF vs Index Funds –
- ETF vs Index Funds Infographics
- What is ETF (Exchange Traded Funds)?
- What are Index Funds?
- ETF vs Index Funds – Similarities
- ETF vs Index Funds – Key Differences
- ETF vs Index Funds (Comparison Table)
ETF vs Index Funds Infographics
Let us understand some of its key differences – ETF vs Index Funds
What is ETF (Exchange Traded Funds)?
An ETF is a basket of stocks traded on the stock exchange reflecting the position of an index like S&P 500 or BSE Sensex. The trading value of the same is based on the NAV of the underlying stock it represents. An instance can be buying and selling of a Mutual Fund in real-time at a price which can change throughout the day.
The fund owns the assets and ownership are broken up into shares held by the investors (shareholders). It offers the privileges entitling them to share in profits such as Interest and Dividends and also residual value on liquidation. The structure can vary depending on the country in which it is operating.
Distributors will buy or sell ETF’s directly from or to Authorised participants which are established broker-dealers and have executed agreements in the past. This is used for computing liquidity of the ETF shares and ensures that the intraday market price will help in arriving at the NAV of the underlying. Other investors such as retail individuals shall avail the services of a Broker and execute share trading in the secondary market.
These funds combine the valuation characteristics of an open-ended mutual fund which can be traded at the end each trading day for its NAV with that of a close-ended mutual fund. The trades take place throughout the day at prices which may be near the NAV of the fund. ETF’s offer efficiency in terms of tax and controlling management costs as well. Few of the benefits of an ETF are:
- Lower costs in comparison to other investment products as most of the ETF’s are not actively managed thus requiring lower marketing, accounting, and logistics expenses.
- These are highly efficient in tax management and generation of lower capital gains as they have a low turnover of their portfolio securities. Since they do not have to sell securities for meeting redemptions of the investors, this offers an additional advantage.
- Transparency is maintained in terms of the portfolios and priced frequently at regular intervals throughout the day.
- The flexibility of trading at current market prices at any point in time during the trading day. The shares can be purchased on margins and sold short enabling opportunities to hedge highlighting to the investors the sweet spot of prices at which they can trade.
- The characteristics of ETF’s offers sufficient market exposure and diversification opportunities. For institutional investors in specific, easy asset allocation is offered coupled with hedging and efficient use of excess cash.
- For arbitrageurs, these funds provide simple and low-cost options to execute arbitrage between futures and cash market.
What are Index Funds?
These are mutual funds designed to track the performance of a specific index. The portfolio is created to replicate the performance of the specific index and holding the securities in the same proportion as per the actual index. Hence, the value of the portfolio will be in the same direction as of the index i.e. if index rises, the value of portfolio rises and vice-versa. Such funds are available for most types of indexes and replication may either be precise or securities with special characteristics such as Financial ratios performance, Geographical location etc.
One of the most established index fund is the Vanguard Total Stock Market Index (VTSMX), and charges just 0.17% per year.
The performance would not be identical to that of the actual index due to the management fees getting imposed thereby reducing returns. Additionally, the weightage of particular securities may not precisely match the weightage of securities in the actual index. The degree of difference in the fund and the actual index is called as the ‘Tracking Error’. Some of the unique benefits of such funds are:
- It offers diversification through a broad exposure to a large group of companies making it less volatile in comparison to individual securities. Foreign index funds offer diversification overseas less costly and less difficult whilst offering exposure to foreign market and market segments.
- Trading of shares of an index fund is more convenient than individual shares and since such shares are traded in massive quantities on a daily basis on the exchanges every day, more liquidity flows into the market.
- These funds pass on the accumulated dividends paid on the underlying stocks which can be a significant amount.
- The possibility of an index fund capturing broader market returns is much more than mutual funds being able to beat indexes which will optimise portfolio returns as per efficient market hypothesis.
There are a couple of drawbacks which are to be known as well:
- Since the index fund managers have to follow the policies and strategies requiring performing in line with the index offering lesser flexibility then managed funds. Investment decisions on index funds have to be made within the restrictions of matching the index returns. For e.g. if the returns on index are falling constantly, the fund managers have limited options to restrict the losses. On the other hand, managers of actively managed funds have more flexibility to act according to the market situations.
- An index fund does not carry the potential for outperforming the market the way managed funds can. Thus, such funds will generally not exceed the market performance due to the underlying objective of tracking in line with the index.
ETF vs Index Funds – Similarities
There are some factors which make both these funds similar in nature and stated below:
- Both of them are classified under the head of ‘indexing’ as it involves making an investment in an underlying benchmark index. The objective is to beat actively managed funds in multiple ways.
- They have low expense ratios compared to actively managed funds
- Funds are managed professionally and aim to reduce risks through diversification.
- They have a Net Asset Value determined as Total Value of the Underlying assets minus Fees / Total Number of Shares
ETF vs Index Funds – Key Differences
The differences between pertaining to ETF vs Index Funds are discussed:
- ETF is a fund which will track a stock market index and trade like regular stocks on the exchange whereas index funds will track the performance of a benchmark index of the market.
- The pricing for ETF takes place throughout the trading day but index funds get priced at the closing of the trading day.
- Trading fees for an ETF are high and expense ratio ranges from 0.1-0.5% which is adjusted to the price whereas index funds have no Transaction fee or commission.
- In the Indian market, the minimum investment for an ETF is Rs.10,000 and index funds requires a lumpsum payment of Rs.5000 or Rs.500 if the SIP (Systematic Investment Plan) is accepted. This amount of minimum investment will vary as per the country and applicable laws. Investment through SIP is not applicable for ETF’s.
- The pricing for an ETF depends on the demand and supply of securities in the market but pricing for an index fund is as per the NAV (Net Asset Value) of the underlying asset.
- The aspect of flexibility and liquidity is comparatively higher in ETF as the intra-day pricing enables traders to transact with greater flexibility rather than index funds as the NAV, in this case, is computed only once a day.
- A trading/brokerage account is essential for buying and selling of ETF’s but no such requirement in case of an index fund.
- ETF does not involve any entry/exit load but Brokerage, Management fees, and taxes are charged. Index fund involves Management fees and exit load is applicable in case of liquidation prior to the stipulated time.
- The application of funds is towards Hedging, Arbitrage and investment of surplus cash for ETF’s but focus for an index fund is the only investment of cash surplus.
- With respect to investment application, ETF’s can be used for long-term investment and trading strategies but for index/mutual funds it is wealth creation over the longer term through equity and debt base.
- ETF’s may have lower tax liability since the trade occurs between investors and the open market and the fund manager is not required to sell assets for raising cash requirements and hence less possible to create capital gains liabilities. Capital gains tax gets applicable to the transaction but will not be impacted if the investor is holding onto the shares. Conversely, index funds involve a transaction between the investor and fund manager and if the investor wants to liquidate their share, trading for the same takes place in the market giving rise to Capital gains or losses.
- As ETF’s are traded directly on the open market, they are generally difficult to be traded, an index fund is always routed through the fund manager making it relatively easier to buy a genuine buyer or seller and ensure regular functioning.
- ETF transaction requires settlement time of 3 days whereas index fund requires just a day offering the holders quicker access to liquid cash following a sale.
- Though trading of ETF’s reflect the real-time environment of the market, as they are not directly associated with the NAV, they are susceptible to manipulations which may not be acceptable to risk-averse investors with preference to stable investment. Index funds cannot be sold short and generally offer more stability for conservative investors.
ETF vs Index Funds (Comparison Table)
|BASIS FOR COMPARISON – ETF vs Index Funds||ETF||INDEX FUNDS|
|Meaning||Fund tracking indexes of a specific exchange.||Fund replicating the performance of a benchmark market index.|
|Base||It will trade like other stocks.||They are like Mutual funds|
|Pricing – ETF vs Index Funds||Done at the end of the day depending on stock price movement||Traded on intra-day basis.|
|Basis for Pricing||Demand and supply of the security/stock in the market||NAV of the underlying asset|
|Trading Costs||Higher costs||No transaction fee/commission|
|Expense Ratios||Low||Comparatively high|
|Initial Investment||No minimum investment||Can be a few thousand dollars or purchases in regular investments through SIP.|
|Settlement Time – ETF vs Index Funds||Three Days||One Day|
It can be concluded that both Index funds and ETF’s have its benefits and drawbacks but both are handy tools for allowing diversification at low prices. The amount of investment and the risk appetite of the investor are the aspects to which the investment narrows down upon. Despite being largely similar in nature, they are different and inexperienced investors in the stock market have to study all the aspects before making any choice. A retail investor shall be attracted towards index funds since they are simpler and cheaper to manage with minimum initial investment options. Institutional investors can consider ETF as they offer tax sops and features similar to regular stocks.
ETFs and open-end index funds are similar in many ways however they distinguished in many aspects. It is pivotal to set clear the goals of investments for effective selection of suitable investment. For instance, if one requires the flexibility of real-time pricing, or the tax advantages of long-term shareholding, ETFs could be a good fit.
On the other hand, ETFs are more exposed to market volatility which may be unattractive towards traditional and conservative investor, or if one wants to earn regular income without dealing with short-term price fluctuations. Although some bond-focused ETFs exist, index funds may be a better choice if investors are looking for exposure to illiquid asset classes such as municipal and international bonds. In the end, personal preference comes down to need for liquidity, the disposable income for investment, maturity time and preference of the asset class.