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ETFs or index funds: Which should you choose?

Both ETFs and index funds are passive products that track an underlying index. We assess the pros and cons of both to help you make the right choice

ETFs or index funds: Which should you choose?

In the previous articles of this series, we talked about exchange-traded funds, or ETFs, and how to choose them. ETFs track a particular index, such as the Sensex or the Nifty 50, and trade on a stock exchange, just like stocks. Because they comprise a fixed set of stocks, investing via ETFs is also called 'passive' investing. Apart from ETFs, index funds are also passive products that track a particular index and aim to provide returns in line with those of the underlying index. So, what's the difference between the two? Which should you prefer? Here's some help.Price quotes: ETFs are real-time products that trade on a stock exchange. So, their prices are available throughout the trading day and tend to fluctuate just like stock prices. On the other hand, index funds are like normal funds where you get to know the price (which is the net asset value or NAV) only once during the day.

ETFs also have NAVs and ideally, the price of an ETF should move in tandem with its NAV. However, the mismatch between demand and supply can cause ETFs to trade at a premium or discount to their NAVs. That's not so with index funds, where you can be certain that you will be allotted units at the NAV only.

Liquidity: The liquidity of ETFs is an important parameter to consider while investing in them as it determines the ease with which you can buy or sell the ETF units. Entities called 'authorised participants' (APs) play an important role in maintaining the liquidity of ETFs. Based on the demand for an ETF, APs create or extinguish ETF units on a stock exchange. An ETF that has more demand tends to be more liquid. Moreover, the liquidity of ETFs also depends on the underlying index. ETFs tracking major indices, such as the Nifty 50 and the Sensex, tend to be more liquid than those tracking niche indices.

In the case of index funds or any regular mutual fund, you are allotted units by the AMC irrespective of the demand. In the case of redemption, the onus lies with the AMC to return to you the investment amount.

Cost: The ETFs have an edge over index funds in terms of cost. The expenses of ETFs tend to be lower than those of the corresponding index funds.

Need for a demat account: Investing in ETFs requires a demat and a trading account, while no such account is needed for index funds. For investors who do not already these accounts, the maintenance charge linked with them could be an additional expense.

Investors who do not wish to open a demat account can invest in a fund of funds (FoF) that in turn invests in the desired ETF. These funds have the characteristics of regular mutual funds, irrespective of whether the underlying fund is an ETF or not. However, the drawback of FoFs is that they are subject to dual expenses: one of the FoF and the other of the underlying fund.

While choosing between an ETF and index fund, investors need to weigh the pros and cons of both the passive avenues. Broadly, if you are seeking convenience, index funds are likely to be the right choice. But if you want cost advantage, ETFs are likely to be the better alternative.

Disclaimer: Mutual fund investments are subject to market risks, read all scheme related documents carefully.
All Mutual Fund investors have to go through a one-time KYC (Know Your Customer) process. Investors should deal only with Registered Mutual Funds (RMF).
For further information on KYC, RMFs and procedure to lodge a complaint in case of any grievance, you may refer the Knowledge Center section available on the website of Mirae Asset Mutual Fund.