What Are ETFs (Exchange Traded Funds)?
ETFs are a basket of securities that mirror an underlying index. In other words, the makeup of the ETF portfolio is proportionally identical to that of an index if they are tracking an index, some ETFs also track commodities such as gold and silver. These funds may invest in equities, bonds, commodities, or a combination of these asset classes.
In contrast to unlisted mutual funds, ETF prices change throughout the day. In addition, because these funds essentially replicate an index’s performance or that of a commodity, they are not actively managed by a portfolio manager. Consequently, they do not endeavour to outperform their respective indices.
Theoretically, there is a variety of ETFs available to investors. They may be used for hedging, speculating, income creation, or offsetting portfolio risk. ETF types include gold ETF, bond ETF, currency ETF, commodity ETF, and equity ETF, among others.
What Are Index Funds?
A type of mutual fund whose portfolio mirrors a stock market index is an index fund (e.g., Sensex, Nifty, Bank Nifty, etc.) In other words, the portfolio of index mutual funds corresponds to the components of the financial market indices. In addition, these funds do not depart from their benchmark index regardless of market conditions.
Low portfolio turnover, broad market exposure, and a low expense ratio are characteristics of index mutual funds. Consequently, these mutual funds are also known as passive funds, as they mirror the benchmark’s portfolio. In addition, these funds are appropriate for long-term (10+ years) investors and those who do not wish to regularly check their holdings.
An index defines a market sector. In other words, an index is composed of securities that belong to the same market category. These divisions consist solely of equities or bonds. For instance, an index fund that tracks the NIFTY 50 will contain the same 50 stocks in the same proportions. The fund manager does not choose the stocks; instead, they mimic the benchmark. Index fund returns are roughly equivalent to those of the benchmark. However, there would be a little variation in performance between these funds and the benchmark, known as the tracking error. In addition, the expense ratio of these funds is lower than that of actively managed funds.
What do Index Funds And ETFs Have In Common?
It is important to understand that Index Funds and ETFs are not necessarily mutually exclusive, a mutual fund can be an index fund and an ETF at the same time. A mutual fund which is tracking the Nifty 50 and is listed on an exchange will be ETF and an index fund at the same time.
The strategy employed by all index funds and the majority of ETFs is passive index investing. This strategy aims to passively mirror the performance of an underlying index, offering easy diversification and sustainable returns over the long run.
- Diversification
Investing in index funds and ETFs is an easy method to diversify your portfolio. Depending on the index they imitate, both provide exposure to hundreds or thousands of equities. This can significantly reduce the risk that your portfolio may be negatively affected by large market fluctuations.
Individual stock prices may fluctuate significantly from day to day, while the Nifty 50 historically has lost or gained on average less than 1 percent per day. Investing in an index fund or ETF that tracks the Nifty 50 does not protect you from any or all losses, but it does lower the risks and volatility you might face if you simply held a few individual equities.
- Low Fees
Historically, the Long-term performance of some actively managed mutual funds has lagged behind that of broad-based, passively managed ETFs and index funds.
An elite minority of active managers may achieve outstanding outcomes over shorter periods by selecting specific stocks. Still, it is very difficult for them to maintain a positive performance record across decades. BSE India reports that more than 65 percent of actively managed funds underperformed their benchmarks throughout the ten years ending in December 2020.
What does this signify for your index fund or ETF investment? From June 1999 to February 2021, the Nifty 50 Index has generated annualized returns of 13.5%. There will be years when it is higher and years when it is lower, but on average, your money will double every 7.2 years.
- Expense Ratio
The expense ratios of index funds and index ETFs are typically significantly lower than those of actively managed products. Although they may appear inconsequential, expense ratios can have a big impact on your long-term returns. Investing passively and indexing your portfolio decreases your overall expenses and leaves more of your capital at work.
Index Fund vs. ETF: Difference between them?
- Trading Approach
Not all index funds are listed on the stock exchange, however, all ETFs are listed on the stock exchange, therefore their units can be traded on the stock exchange just like shares. This is because ETFs, like stocks, can be traded throughout the day on exchanges. Consequently, the price of an ETF fluctuates during trading hours.
Index funds, on the other hand, if unlisted, can only be bought and sold at a price that is announced at the conclusion of each day. This is not a significant worry for long-term investors. However, if you are an investor seeking to time the market, ETFs with features such as intraday trading, stop losses, order limitations, etc., can be useful.
Due to the fact that ETFs are traded on exchanges, investment in ETFs requires both a trading account and a Demat account. However, purchasing an index fund can be less complicated. You can use zero commission investment platforms like Kuvera to invest in index mutual funds in a hassle-free manner.
- Fund Management
ETFs can be passively managed or actively managed funds, whereas Index Funds are passively managed instruments. Currently, actively managed ETFs make up roughly 20% of all ETFs in the US, India almost all of the ETFs are passive mutual funds.
This indicates that the fund manager is not deploying his own strategy for investment but following an index or a commodity and is investing in those companies which constitute the index or in the commodity which is being tracked.
However, ETFs need not always be passive. Theoretically, By copying the portfolios of well-known investors like Warren Buffett or Rakesh Jhunjhunwala, for instance, an ETF can be created to replicate their investments, however, in India, an overwhelming majority of the ETFs are passive funds. In the USA, ARK Innovation ETF is another illustration of an innovative ETF.
This ETF is solely focused on “disruptive innovation,” which includes investing in businesses that develop DNA technology, industrial innovators, health technology, and next-generation Internet businesses. Therefore, the most important lesson is that while Index Funds are passive, not all ETFs are.
- Liquidity
The mutual fund provider simply adds your funds to its AUM when you invest in an index fund and then goes about its business of purchasing securities in line with the benchmark. There is no genuine risk on the liquidity front because, with Index Funds, the exact reverse occurs when you want to redeem.
However, in the case of an ETF liquidity can be a concern if the market is going through a bear run and there are not many buyers in the market.
That’s because purchasing an ETF is similar to purchasing any other equity share, unlike an Index Fund. Consider a situation in which you want to sell 100 units of your ETF but there aren’t any interested parties. The liquidity issue with ETFs puts you in a catch-22 situation where you won’t be able to sell any of your ETF units for the price you want to.
In some ETFs, however, the situation in India is unquestionably getting better in terms of liquidity. But there are still certain sectoral or smart beta ETFs with modest trading volumes where liquidity is a problem.
- Tracking Error
Exchange Traded Funds (ETFs) can follow an index more closely than Index Funds since they are more likely to have a lower tracking error. This is so that redemption requests can be honoured because Index Funds typically keep some cash on hand at all times.
An asset management company has no such duty in the case of ETFs. As previously stated, ETFs are traded like stocks and can be sold only if a buyer is found on the exchange. There is no part for the AMC in this. The reason for a marginal higher tracking error is therefore due to the liquidity that Index Funds offer.
Deploying Index Funds also takes time when funds are received in small amounts. This results in the investment manager holding cash in the index funds. As an illustration, consider a NIFTY 50 Index Fund.
The Index is made up of 50 equities with various weights. Therefore, the fund manager of an index fund is required to invest every rupee received each day in the same ratio as the index. Consider a scenario in which the fund manager needs Rs. 15 lakh to purchase each of the 50 stocks in NIFTY 50 in the same ratio as the index.
However, the fund got Rs. 10 lakh on a specific day. The fund manager will therefore have to wait till he or she has an additional Rs. 5 lakh in order to purchase all 50 equities in NIFTY 50 in the same ratio as the index.
- Expense Ratio
ETFs and Index Funds have lower expense ratios than actively managed mutual funds, which is the cost charged by mutual fund firms to handle your money. However, when comparing ETFs with Index Funds, ETFs are typically less expensive than Index Funds.
For instance, the expense ratio for the HDFC NIFTY 50 ETF is only 0.05 percent, however, the Index Fund variation, i.e. the HDFC NIFTY 50 Index Plan, has a direct expense ratio of 0.20 percent. That is an additional 0.15 percent, or if you prefer to view it another way, a 300 percent premium over ETF prices (data last verified on 3 August 2022).
Nonetheless, investors in ETFs should be mindful of two additional expenses. The first of these additional expenses is your broker’s commissions, i.e. the trading platform. Typically, the broker’s commission is a percentage of the amount transacted or a flat fee per transaction. This commission or fee typically comprises a variety of expenses, such as commission, GST, STT, stamp duty, exchange fees, SEBI turnover tax, etc.
Before determining the total cost of ETFs and comparing it to the expense ratio of Index Funds, you must therefore take into account the aforementioned expenditures.
- SIP
Systematic investment plans, or SIPs, are a popular way of investment for regular investors. While Index Funds typically offer the SIP option, ETFs typically do not.
Therefore, the absence of the SIP route in ETFs is a significant disadvantage, as the SIP route continues to be a highly disciplined and consistent method for investors to engage in the equity markets.
Consequently, if you are one of those investors who are more comfortable investing in equities via SIP, then index funds may be the way to go at this time.
Both ETFs and index funds have their benefits and limitations, as demonstrated by the above comparison. Moreover, both products offer low-cost portfolio diversification. Therefore, an investor must undertake thorough research and choose a fund that aligns with their financial objectives, risk tolerance, and investment horizon.
FAQs
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Can index funds be traded on the stock market?
No, they are not listed on the stock market. However, ETFs can be traded like equity on the stock market
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What are the top index funds in India?
Nippon India Index S&P BSE Sensex, HDFC Index S&P BSE Sensex Fund, and Tata S&P BSE Sensex Index Fund, are the top performing index fund in India as per 5-year return (Source: AMFI data as of 02/08/2022).
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What is the expense ratio?
The expense ratio (ER), sometimes known as the management expense ratio (MER), depicts the percentage of a fund’s assets that are allocated to administrative and other operating expenses.
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