Invested in mutual funds and looking for further diversification at a lower cost? Then you must consider other fund options alongside traditional equity, debt or hybrid funds.
Index funds and Exchange Traded Funds (ETFs) are such funds that provide diversification and are mostly passively managed, lowering the overall expenses.
However, although they have some similarities, there are key differences between these two that you must note. With 25.86 crore mutual fund folios across India, invest in one of them which suits your goal by learning their definition and differences here.
A Brief Definition of an Index Fund
A mutual fund means pooling money from investors and allocating it across equity, debt or a mix of both. However, when talking about an Index fund, you must note that, unlike an equity or debt fund, it is a passively managed fund. It means that such a fund replicates the market indices, such as the Nifty or Sensex, by investing in a similar segment of securities that make up those indices.
Emphasising more on the term passive fund, here, unlike an active fund, there is no active stock selection by a fund manager involved. Here, the holdings of such funds try to mirror their respective benchmarks and do not attempt to outperform them.
This passive approach results in lower management costs. For example, the expense ratio that funds impose as a management fee is lower, around 0.1% on average. Also, with a lower chance of human bias, it allows for diversification at a better cost efficiency.
A Quick Look at the Exchange Traded Funds (ETFs)
As its name implies, an ETF resembles a mutual fund but trades like a stock across the stock exchanges. However, a fundamental difference from a mutual fund is that you can buy and sell ETFs throughout a trading day at the prevailing market prices.
Here, the objective is quite similar to an index fund, such that it also tries to mimic the performances of assets, sectors or indices. They include indices like the Nifty or Sensex, assets such as equities, bonds, commodities, currencies, etc.
Once an ETF gets formed, you can see it listed on the stock exchanges. As an investor, you can buy or sell ETFs just like a stock.
While using the XIRR in mutual fund tells you the growth of your entire investment, in ETFs, you might make a growth as the price changes and goes upward throughout a trading day.
Key Differences Between the Index Funds and ETFs
Now that you have an idea of how these two types of investment vehicles work, you must note their differences in detail:
Parameters | Index Funds | Exchange Traded Funds |
Objective of investment | Replicates specific market indices such as Nifty or Sensex and holds the same amount of assets as its respective index. Here, the mutual fund house buys and sells the fund units. | Mimics the performance of market indices, stocks, commodities, etc. On the stock exchanges, the ETFs are traded, and investors can directly buy or sell them like equities. |
Method of pricing | Similar to actively managed funds, you buy fund units at the prevailing NAV. | Here, the market movement influences the ETF price, which fluctuates throughout a trading day. |
Expense ratio | Here, the expense ratio might be slightly higher than that of an ETF. However, overall, it is lower than actively managed funds. | The expense ratio here is typically lower. |
Liquidity | Based on factors such as redemption process, cutoff time, etc, the liquidity here is moderate. | Liquidity is much higher here, and as an investor, you can enter and exit the market throughout a trading day. |
Conclusion
Index funds are passive mutual funds that replicate the performance of a certain market index. ETFs, on the other hand, track indices and asset classes and trade on stock exchanges like a stock.
