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Choosing between index and exchange-traded funds

Here is a comparison of index funds and ETFs with respect to three essential parameters - convenience, cost and liquidity

Choosing between index and exchange-traded funds

Passively managed funds are slowly but surely making inroads into the mutual fund industry. This is particularly evident in the large-cap category, where these days most actively managed funds are struggling to outperform the benchmarks.

When it comes to investing in passive funds, investors often face a dilemma about whether to opt for an exchange-traded fund (ETF) or an index fund. To overcome this dilemma, it is necessary for investors to compare the two with respect to three essential parameters: convenience, cost and liquidity.

If you want to invest in ETFs, you should have an active trading and demat account. ETFs are traded on the stock exchange just like equity shares. You buy the units of an ETF from the secondary market using your trading account and these units are later delivered to your demat account. For a seasoned stock investor, doing this may be as easy as shopping online, but not for someone with inadequate experience in stock trading. Besides being KYC-compliant, you'll need to open a trading account and a demat account with a broker.

On the other hand, if you want to invest in an index fund, you will only need to be KYC-compliant. Anyone who is KYC compliant can simply visit the website of a fund house and invest directly in the index fund of his choice, similarly to how you would invest in any other mutual fund scheme. Unlike with an ETF, you can also opt for a systematic investment plan (SIP) in index funds.

Like any other mutual fund, ETFs and index funds also come with an expense ratio, which is charged by the fund house. Although the expense ratio of index funds (the graph below) is usually higher, it is the only cost you need to bear.

On the other hand, for ETFs, there are other charges as well. You will need to pay a certain percentage of the transaction value as brokerage to your stock broker. It is applicable for both buying and selling your ETF units. The rate of brokerage varies from broker to broker but may range between 0.10 and 0.50 per cent. Some brokers charge a flat fee instead of a percentage of the transaction value.

Besides brokerage, you will also need to pay annual maintenance charges for your demat account, which can range from Rs 200-500.

As mentioned earlier, ETFs are traded on a stock exchange. For a small investor, it's the only way to buy and sell their units. But since they are not yet a mainstream investment vehicle in India, their trading volumes lack depth. Seven out of the 14 ETFs tracking the Nifty 50 Index have clocked a daily average turnover of less than Rs 1 lakh in the past six months. This is a major concern while investing in ETFs.

Another concern is the traded prices of ETF units, as they diverge significantly from the fund's NAV. So, if the units trade at a discount to the NAV when you sell, it will be a loss for you.

On the other hand, you will not face any such issue with an index fund, as the fund house always assures liquidity with this fund. You can buy and sell the units of an index fund directly from the fund house at the stated NAV.

The verdict
To put it in a nutshell, if you already have a trading and demat account for your stock investments, investing in ETFs may not be troublesome or costly for you. If not, it may be difficult. Nevertheless, liquidity is an area where ETFs lose out compared to index funds. Given all these constraints, some fund houses have started offering fund of funds (FoFs) for their ETFs.