Index fund or ETF?

By Morningstar |  28-06-21 | 

How must one decide between an ETF or an index fund, since both are passive forms of investing?

First, be clear that when it comes to investing, it is never an either/or strategy.

When considering allocation to passive funds, it need not be to the exclusion of active funds. An investor can invest in both, active and passive funds. Don’t view passive funds as a competing strategy but rather, a complementary strategy.

Apply the same logic within the passive universe.

The decision on whether one must invest in an Exchange Traded Fund (ETF) or index fund depends on the need of the investor.

Select entities (certain trusts, cooperative societies) whose existing laws and mandates do not permit the operating of a trading and demat account, would opt for index funds. If you are a trader, you might prefer an ETF due to its real-time prices to exit and enter. Though some institutional treasuries and family offices take tactical calls by investing in certain index funds.

By and large, index funds would meet the need of most retail investors. Those who wish to invest for the long term and are not concerned with intraday prices. Also if you are investing systematically, via a systematic investment plan (SIP), then an index fund is the right vehicle, not an ETF. The appeal of passive investing lies in its simplicity and low-cost structure. Even if you do not have a demat account or a stock broking account, you can access the equity market via an index fund.

If it is something specific you are looking for, then you will not have the luxury of a choice. The Nifty 100 ESG Sector Leaders is an ETF, not an index fund. Ditto with Nifty 50 Shariah. In the case of Nifty Bank, you will have both, index and ETF. But in the case of Nifty Private Bank and Nifty PSU Bank, you only have ETFs.

Once you narrow down on the type of fund you would like in your portfolio, check the expense ratio. Index funds have direct plans, apart from regular plans. There is a difference in the total expense ratio, or TER between the two plans. In an ETF, investors need to look beyond the TER. They must look at the total cost of ownership, or TCO. This includes all expenses (brokerage, taxes paid on buy and sell transactions on the stock exchange, annual demat account charges, bid/offer spread, etc.).

Specific to ETFs…

In ETFs, there is often a difference between the fair value of an ETF and the prices quoted on the exchanges. This is all the more evident if there is inadequate liquidity on the exchange.

Review the past trading volumes of an ETF before investing in it.

Investors can also easily check the real-time INAV (indicative NAV) before executing a trade on the exchange – the INAV which indicates a real-time fair value per unit is mandatorily published on the website of the AMC. If a retail investor wants to exit and if he/she doesn’t get the fair value, then the overall investment experience is bad.

Look for ETFs where the divergence between INAV and the price traded is minimum.

Illiquidity is a relevant concern. If there aren’t enough buyers for your trade, you may not get your desired price if the ETF is illiquid.

ETFs have two layers of liquidity: liquidity of the underlying securities (primary market), and the liquidity of the ETF units traded (secondary market). Liquidity is provided by market makers who take the opposite side of the trade by buying and selling ETF units.

One way to ascertain the liquidity of any ETF is by looking at its trading volumes. Low trading volumes could widen the bid-ask spread, while high trading volume will narrow this spread. Bid is the price you are willing to pay and ask is the price seller quotes.

Consider ETFs where trading volumes are high.

Greater the size of assets under management, or AUM, more telling the indicator. This indicates a higher level of investor interest in the fund. A large AUM enables funds to cut costs and pass them on to investors by way of a lower TER. A lower TER means higher returns. Which is what every investor ultimately wants.

Ideally, go for ETFs which have a higher AUM.

If you find all of this complicated, stick to an index fund.

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