Exchanged Traded Funds (ETFs) and index funds are inexpensive ways to build a diversified equity portfolio.
Both are passive systems. Both seek to replicate (rather than outperform) the performance of a benchmark index. For example, both the Nifty 50 ETF and the Nifty 50 index fund try to track the performance of an index fund.
This is achieved by keeping the constituents in the same proportion as in the Reference Index. If Nifty 50 has 15% Reliance Industries and 10% HDFC Bank, the Nifty ETF and Nifty 50 index fund portfolio also have 15% Reliance and 10% HDFC Bank. No discretion.
The returns of an ETF and an index fund (on the same benchmark) are expected to be similar.
Then what is the difference between the ETFs and the index funds? Which is better: an ETF or an index fund? Where should you invest?
Let’s find out in this post.
Read: What are Exchange Traded Funds (ETFs)?
Index Fund No. 1 Compared to ETFs: Buying and Selling (Transaction Ease)
A fundamental difference here.
You buy index funds from the asset management companies (AMCs or mutual funds). You are selling an index fund to an AMC.
You are buying ETFs from another trader. You are selling to a dealer. Buying / selling ETFs is like buying / selling a stock.
If you are a large investor, you can buy the ETF creation unit directly from the AMC. For example, you can buy Nifty ETF directly from ICICI Prudential for ~ Rs 80 lacs (as of May 17, 2021).
# 2 Index Funds vs ETFs: Liquidity
Liquidity is not an issue for index funds as you buy and sell with AMCs. The AMC must ensure liquidity.
Liquidity can be an issue with ETFs as you buy and sell from other investors / traders.
If you want to buy you need to find a seller.
If you want to sell, you have to find a buyer.
While we may believe that ETFs with a larger AUM are more liquid, this may not always be the case. ETF liquidity is a function of the liquidity of the underlying securities and the market making level of the ETF. For more information on the liquidity of ETFs, see this document.
# 3 You can buy / sell ETFs all day long
Advantage of ETFs.
The markets suddenly fall in the morning. They think this fall is only temporary and the markets will recover in a matter of hours. Let’s say Nifty opens at 15,000, goes back to 14,500, but jumps back and closes the day at 15,000.
Can you take advantage of such an intraday decline in the market?
Not with index funds.
You can ONLY buy and sell index funds at the end-of-day NAV (linked to the end-of-day index level). Therefore, you cannot take advantage of intraday volatility through index funds.
Yes with ETFs.
However, ETFs let you buy / sell all day, just like stocks. This is how you can take advantage of intraday volatility via ETFs.
Whether or not such intraday trading is useful is another question, but ETFs give you that flexibility. Index funds do not.
# 4 ETFs have no concept of Regular or Direct
Index funds are offered in both direct and regular versions. You save commissions when you invest in direct index fund plans.
No such concept with ETFs.
You buy ETFs on exchanges and that’s it.
On the ValueResearch website, ETFs are displayed in the REGULAR section. This can be misleading. No commission is paid to anyone buying ETFs. It’s like stocks where you pay brokerage fees (and not commissions).
# 5 ETF vs. index funds: transaction costs
Advantage index fund.
There are no transaction costs when buying investment funds (except for stamp duty).
There are also no transaction costs when selling (expect STT).
Since you have to buy and sell ETFs on the exchanges, you have to bear regular trading costs like brokerage fees etc.
If you work with a traditional broker or a full service broker like ICICIDirect, these fees can be very high.
If you buy ETFs through an index fund just for cost reasons, those transaction costs can wipe out years of upfront savings.
Let’s say Nifty 50 ETFs have an expense ratio of 0.1% (10 basis points). A Nifty index fund has an expense ratio of 0.15% (15 basis points). You choose ETF because the expense ratio is 5 basis points lower.
Now, if you have to prepay a brokerage (plus other fees and GST) of 50 basis points to buy the ETFs, you have prepaid 10 years of cost savings. You save 5 basis points (0.05%) when you invest in ETFs. However, for such savings, you pay 50 basis points up front. Not much point, is it?
The same transaction costs apply when selling.
So pay attention to this aspect.
When you work with a discount broker like Zerodha, brokerage isn’t a huge problem.
# 6 ETFs vs Index Funds: Expense Ratio and Tracking Error
ETFs tend to have lower expense ratios than index funds.
I am copying the following data on HDFC and SBI ETFs and Index Funds from the ValueResearch website.
Above you will see “ETF” somewhere in the names of the ETF systems. The expense ratios are lower than for index funds. The difference is even bigger when you compare the expense ratio of the ETF to the expense ratio of regular index fund plans.
However, there is no such rule that the expense ratios of ETFs have to be lower than those of index funds. Usually AMCs will charge whatever they can get away with.
From AMC’s point of view, ETFs are easier to manage compared to index funds. In the case of index funds, the AMC must manage the inflows into the system and the outflows from the system. The AMC must provide unlimited liquidity to investors (investors can repay at any time).
No such problem with ETFs. Once the ETF shares are issued to the AMC, buying and selling is your headache. You have to find buyers and sellers in the stock market. The AMC is not disturbed. All you need to do is rebalance the underlying portfolio when the benchmark index changes and manage the dividends from the underlying stocks (this is what happens with index funds too).
This partly explains the lower expense ratio of ETFs. In addition, for the reasons mentioned above, it is likely that ETFs will have lower tracking error than index funds.
By the way, we don’t just have Nifty 50 or Nifty Next 50 ETFs. There are also ETFs on other indices. On such indices, AMCs charge a much higher expense ratio (than shown in the figure above).
# 7 price and NAV
What is the net asset value?
For mutual funds (including ETFs and index funds), the net asset value is simply the value of the underlying assets divided by the number of units / units in issue.
Suppose a mutual fund 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 = number of shares of A * last traded price of B + number of shares of B * last traded price of share B.
1000 * 100 + 1000 * 50 = Rs 1.5 lacs
Now suppose the AMC has issued 10,000 units of the MF system.
In this case, the net asset value of the scheme = 1.5 lacs / 10,000 = 15.
You can only buy and sell index funds at the end of the day. And that is the price of the index fund unit.
However, you can buy and sell ETFs during the day. And the price (at which you buy / sell) may differ from the net asset value.
In addition, the market price of stocks A and B will fluctuate throughout the day. As the price of the underlying stocks fluctuates, the net asset value of the ETF will also fluctuate.
Ideally, you want to buy or sell that close to the ETF NAV. Therefore, you want to place your bid or bid at the real-time net asset value (and not the previous day’s closing net asset value).
But how do you find out the real-time net asset value of ETFs? Fortunately, AMCs publish such a real-time net asset value on a regular basis. You can check real-time NAVs on the respective AMC websites. Nippon India AMC, ICICI Prudential AMC.
I checked the real time net asset value of Nippon India Junior Bees (Nifty Next 50 ETF) and offered / asked offers on NSE.
At that point in time the real-time net asset value was 377.78. So if you’re a buyer, you don’t want to buy anything more than real-time net asset value.
However, even the best bid is higher than the real-time net asset value. Not good.
Sometimes the gap between price and net asset value can be much wider.
If you want to invest in ETFs, consider this aspect when choosing the ETF.
Index Funds Vs ETFs: Which Should You Choose?
In my opinion, ETF is a superior product as an index fund.
However, buying / selling ETFs is a challenge, at least for now.
To invest in ETFs, you need a Demat account. You need to understand the difference between price and net asset value. You must try to buy as close to real-time net asset value as possible. Work with an inexpensive broker. You need some trading skills.
You cannot run SIP in ETFs. Thus it is difficult to automate investments. Some brokers may allow a similar setup through market orders, but market orders can be a risk for ETFs with low liquidity, higher bid-ask spreads, and large differences between price and net asset value.
Some AMCs have fund-of-fund (FoF) programs that invest in the ETF. For example, ICICI Prudential has launched a low volatility FoF that invests in low volatility ETFs. With FoFs, you don’t have to worry about buying / selling the underlying ETF. The AMC would do it. Makes it easier for investors. You don’t have to worry about liquidity. You can also do a SIP.
However, you need to understand that the FoF structure occurs twice as often. The cost of the FoF and the cost of the underlying ETF. It would have been better if the AMC had simply launched an index fund.
Despite various advantages of ETFs, I will stick with index funds (or even FoFs in some cases) for now because the transaction and execution are straightforward. My mind may change in the future.