Investing in Index Mutual funds vs ETFs , which one to choose?

 

Investing in Index Mutual funds vs ETFs , which one to choose?

When it comes to passive investment schemes on stock market Index Mutual Funds and ETFs stands out, these investment instruments are the once that track standard index like Nifty50, Nifty Next50 or Gold etc. This might be considered as good investments as the weightage of stocks will be same as that of the underlying index and most managed mutual funds fails to even beat the Nifty50 index.

What is index Mutual funds?

The asset allocation an index fund tries to replicate that of a popular index that it is trying to emulate like Nifty50, Gold or Nifty Next50. Since we can’t invest directly in standard index AMC will create a index fund with weightage similar to the index. Therefore, index funds having tracking error. The deviation of the returns that an index fund would generate from the returns that of its underlying index is directly proportional to the tracking error.

What is ETFs?

ETFs or Exchange traded funds are funds that mostly trade in the intraday shared market and click the profits at the end of the day. ETFs are highly transparent in nature, where investors get to know exactly their investments are allocated.

Like index funds, ETFs are also affected by the share market, and these transactions take place on a real-time basis.

Why should you invest in passive index funds or ETFs?

The truth is most mutual funds try to beat the index but fail at doing it, also if you try to buy stocks on your own then chances are you are still going to fail at beating the standard index, check the below image of Nifty50 index return for past 22 years. The CAGR for nifty50 index is around 16% which is awesome.

Nifty50 return for last 22 years with CAGR of ~16%

Should you opt for ETFs or Index Funds?

In this section I will walk through differences between ETFs and Index Mutual funds, so that you can choose what works for you.

Liquidity: The most important thing to know is that when you buy an index fund from an AMC it adds to the AUM of the Fund. On the other hand, when you buy an Index ETF you do not add to the AUM of the ETF, but you can buy or sell only if there is counter party to the trade. So, availability of market liquidity is paramount to the choice of an index ETF.

Time of Buying or selling: An index fund being a mutual fund is available for purchase or sale only at the end of day (EOD) NAV. You can buy index funds during the trading hours. Index ETFs, on the other hand are available to buy and sell during the trading hours at a price that reflects the Nifty fraction as closely as possible. This gives greater flexibility to the Index ETF buyer.

Additional Expenses: Expense ratio in an Index ETF is much lower compared to the index fund. For example, in India if a normal index fund has an expense ratio of 1.25% then an index ETF would have an expense ratio of just about 0.35%. However, there is a catch. Since ETFs are bought and sold on the exchange like any other stock, additional costs like brokerage, STT and statutory charges need to be factored in to get the correct picture.

Risk Involved: Both the Index ETF and the Index fund run the market risk or Beta as we popular call it. However, there are two additional risks you need to wary of. Firstly, there is the tracking error risk which is higher in case of index funds compared to ETFs as index funds need to keep larger cash balance to handle redemptions. But Index ETFs run a higher risk of bid-ask spreads widening when markets get volatile.

 

Investment through SIP: One of the most popular methods of investing inequity funds is through the systematic investment plan. This gives the added benefit of rupee-cost averaging which lowers your average cost of owning the units. All mutual funds allow the benefits of SIPs and SWPs. However, when it comes to Index ETFs, the benefit of SIPs is not available as it is like a closed-ended fund. That becomes a challenge from a long term financial planning perspective.

Dividend Payout: There is also an interesting difference between index funds and index ETFs in the way the dividend pay-outs are managed. For example, in case of ETFs since it is like a traded stock the dividends are directly credited to your registered bank account. This again becomes a hassle from a long term financial planning point of view. In case of index funds, you can opt for a growth plan or a dividend reinvestment plan where the dividends are automatically substituted by units. In case of ETFs this reinvestment will have to be done manually.

Taxation: On the taxation front, there is not much to choose between the two. Like in case of index funds, Index ETFs also are charged STCG at 15% and LTCG at 0%.

The two most important criteria you need to consider when making the choice between Index ETFs and Index Funds are costs and liquidity. If liquidity is easily available in the secondary markets without too much of a basis risk, then the lower costs will work in favor of the Index ETFs.

 

ETFs might seem to have a clear advantage over index funds as they come at a lower cost. However, you may not be able to track markets and take decisions accordingly. This may be due to a lack of market knowledge or time constraint. In this case, you can invest in direct index funds as they come at a lower cost than regular index funds.

Also, index funds are handled by professional fund managers, and they take the right decisions depending on the market scenario.