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What is the difference between an index fund and an ETF?

Dhirendra Kumar talks about the difference between ETFs and index funds and their pros and cons

While buying ETFs during market hours, the price is at times much higher than the actual NAV. Due to this, do you think index funds are better than ETFs for the investment purpose? Please explain the difference between index funds and ETFs and suggest one or two good index funds or ETFs.
- Manoj

Yes, ETFs have an issue that they trade at a premium or discount to the NAV. This difference between the NAV and price can be a temporary phenomenon, owing to the demand-supply mismatch. Normally, the premium or discount of price over NAV is in the range of 1-2 per cent. However, this can increase if too many people start selling ETFs, thereby resulting in the price going below the NAV. Alternatively, if too many people start buying the ETFs, the price can be above the NAV.

The problem with index funds is that you can buy it only at the end of the day's NAV. Unlike ETFs, these are not real-time products. Also, index funds are not able to track the index with precision. This phenomenon is called tracking error. This could be because of several reasons. First, as compared to ETFs, index funds are relatively expensive. While most of the ETFs charge about 10-50 basis points, index funds have expenses of about 0.75-1.5 per cent. Also, there is a transition error in index funds, as all money is not deployed immediately. Also, some corporate actions can make the fund inefficient to track the index.

Both index funds and ETFs have pros and cons. Index funds make it easier for investors to invest through an SIP, however; they have higher expense ratios and tracking error as compared to ETFs. So, while investing in an index fund, look for the one that has the lowest expense ratio and while investing in an ETF, look for one that has high trading volume so that the difference between its price and NAV is the lowest. SBI Nifty 50 ETF has the highest AUM and also a significant trading volume and hence, can be a good investment option for investors.