Both exchange-traded funds and index funds try to replicate the index that they track, but the costs associated with them are different
Total cost of ownership includes external costs of owning an ETF, but this is not included in TER (total expense ratio)
If you are one of those investors who prefer to invest in a low-cost and diversified portfolio and do not want to take the risk of fund managers’ wrong calls affecting your investments, passive funds are the right choice for you. Within the passive fund basket, there is a choice between index funds and exchange-traded funds (ETFs). Both types of funds hold portfolios that replicate the index that they track. But there are many subtle differences between the two categories that you should understand before choosing to invest in one.
Buying and selling: Units of index funds are bought and redeemed—both at the time of initial investment and subsequent transactions—directly from the mutual fund company. ETFs need to be initially bought from the mutual fund at the time of the new fund offer (NFO), though subsequent transactions are conducted on the stock exchange where ETFs are mandatorily listed. So the investor must have a demat account to invest in ETFs.
Applicable price: Index funds are bought and sold at the day’s applicable net asset value (NAV), which is taken as of end of day, irrespective of when the purchase request is made.
ETFs, on the other hand, are traded at real-time prices, like stocks, on the stock exchange. ETFs allow investors so inclined to take advantage of intra-day index movements, which is not possible in the case of index funds. Trading on the stock exchange also means that ETF investors can use facilities like limit orders and stop loss to determine the price at which they buy and sell units.
Liquidity: Since index funds are traded directly with mutual funds, you can purchase and redeem them on any day at the applicable NAV.
ETFs are traded between investors and liquidity depends on the demand and supply of units. It may not always be possible to buy and sell ETFs as the investor requires. Moreover, the price at which trades are done may be distorted by the demand-supply situation. If the demand is high and not enough units are on offer, the price may go up, and vice -versa. The price at which units trade may be significantly different from the NAV. Sustained and high difference between the price at which ETFs are traded and the NAV is unhealthy and a sign of illiquidity.
Passively managed funds are expected to closely track the returns from the index since their portfolios replicate the index. The tracking error measures the deviation in the return of the fund from that of the index. Higher the tracking error greater is the risk for the investor.
Index funds are likely to have higher tracking error since they may hold higher cash balances to provide for redemption needs. In case of ETFs, there is no need to hold cash since the funds are not involved in the purchase and redemption of units.
If you are a passive investor, lower cost is likely to be your primary concern. Though ETFs and index funds are driven by similar objectives, the costs associated with them are different. “Over the years, we have become very familiar with the concept of TER as the total expense ratio, i.e., cost including management fees, custody fee, registrar charges, other operating costs and marketing fees (where applicable). This is a recurring cost of ownership of any mutual fund, including a passively managed index fund. TER is transparently disclosed in the fact sheet and on the website of the mutual fund and there are no other implicit costs which the investor has to bear indirectly," said Anil Ghelani, CFA, head, passive investments and products, DSP Investment Managers Pvt. Ltd.
A look at TERs published by mutual funds shows that TERs of index funds are three-four times higher than TERs of ETFs. But you need to dig a little deeper before you decide that ETFs are more cost-efficient.
“When it comes to the total cost of an ETF, for complete transparency on the cost of owning an ETF, the investor should consider the total cost of ownership or TCO. It takes into account the external costs relating to entering, holding and exiting the investment; TER does not include these costs," said Ghelani. However, it is difficult for an investor to find TCO on any fact sheet or website of the mutual fund. “TCO is calculated by adding all the implicit costs of owning an ETF, to any additional external costs that are more visible to the investor such as broking account opening fees, brokerage charge, and the bid-offer spread when the ETF is traded," he said.
So which category should you choose? It will depend on what you are looking for from your investment. Both options allow you to accumulate wealth over time.
Index funds are more straightforward to follow and the value of the investment directly reflects the underlying portfolio. The value of the ETF holding may reflect the demand and supply situation of units along with the underlying portfolio value, which may be misleading. Look for ETFs where the divergence between the NAV and the price traded is minimum. You may also want to buy an ETF if you want to make intra-day bets on the index.