Index funds vs ETFs: Which is better for passive investors?

A lot of Indians have joined the investing bandwagon since the start of the covid-19 pandemic. For most investors looking at simpler solutions, passive funds offer the level of simplicity and returns which can match that of an index.

Passive investing is the most basic form of putting one’s money in mutual funds (MFs) and the purpose of this style of investment is to mirror the index and not beat it. Two common ways of investing passively in the equity market are to either opt for an index fund or an index exchange-traded fund (ETF). Both essentially mirror an index.

It’s only in the past five years that asset management companies (AMCs) have started focusing on passive funds. Motilal Oswal AMC, which started selling passive funds two years ago, has 14 index funds, including four ETFs, now.

“People are also becoming price conscious about how much they pay for mutual funds and have started looking at expense ratios, which they usually didn’t use to do two-three years ago. Moreover, the performance of passive funds is becoming at par with active funds now,” said Pratik Oswal, head of passive funds at Motilal Oswal AMC.

In passive investing, investors don’t have to choose from over 5,000 funds that are available in the market.

According to experts, both index funds and ETFs are good for those looking to hold their investments for the long term. However, these instruments come with their own set of pros and cons. Let’s look at them in detail.

An index fund works like an MF, in which a fund manager creates a portfolio that replicates an index, which could be the Sensex or Nifty. There are over 30 funds available in the market on Sensex and Nifty indices alone. However, the problem with index funds is that you can buy them only at the end of the day’s net asset value (NAV).

ETFs remove this limitation, as they can be bought at any point during the market trading hours. Moreover, ETFs have to be listed on stock exchanges.

There are various kinds of ETFs available in India, right from gold ETFs to Nifty and Sensex. There are also CPSE and Bharat 22 ETFs, which give exposure to public sector companies. There are also niche ETFs called factor-based ETFs; for example, low-volatility and value ETFs. However, experts suggest that only evolved investors should dabble in these niche offerings.

For both index funds and ETFs, you should pick a fund with minimum tracking error. The tracking error is the divergence of an index fund from the index it is seeking to replicate.

While most of the ETFs charge about 0.1-0.5%, index funds have expenses of about 0.75-1.5%.

According to Deepak Jasani, head of retail research at HDFC Securities, ETFs score over index funds in many ways. “You can buy or sell ETFs at any time on an exchange during trading hours, and you can take advantage of your entry or exit based on your analysis or perception of the markets or the index you are tracking. Moreover, ETFs have a low expense ratio than mutual funds and the tracking error is also lower. This makes net returns higher in the case of ETFs,” said Jasani.

One of the key reasons behind tracking error creeping into index funds is the delay in holding adjustments bet-ween the tracking index and the fund.

However, investing in ETFs requires trading and demat accounts and these costs add to the total cost of ownership, along with the expense ratio.

One key downside of ETFs in India is the lack of liquidity. “The issue with ETFs in India is efficiency. Unlike the West, ETFs in India are not very efficient, so investors end up paying about 0.5-1% more than what they should, because of the lack of liquidity on the exchanges; but this will not be a problem in five years’ time,” said Oswal.

Moreover, investors generally can’t do systematic investment plans (SIP) in ETFs. Some brokers though have a do-it-yourself (DIY) facility for SIPs, but at the AMC level, you cannot do SIPs.

Experts say that first-time investors should not buy ETFs on an exchange.

“As a retail investor, you tend to only look at the expense ratio and decide which instrument is cheaper, but ETFs have multiple problems that an index fund doesn’t have. Generally, ETFs are not available at the market rate and the spread is sometimes the problem, which can eat into much more than what the expense ratio of an index will,” said Kirtan Shah, chief financial planner at Sykes and Ray Equities (I) Ltd.

When investing in ETFs, retail investors don’t generally look at brokerage charges. Considering buy-sell brokerage plus the spread, investors might end up paying much more in ETFs than they would have paid for an index.

Low-cost passive investments such as index funds and ETFs are good long-term choices, but make sure that you are getting the advantages of low-cost, efficient transactions in the instrument that you have chosen.