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Out of index funds and ETFs, which is better?

Ashutosh Gupta talks about the pros and cons of index funds and ETFs

I wish to start investing in the index through SIP. Which is better - index funds or ETFs? And which index should I be tracking?
- Rishi Kapoor

Both index funds and ETFs are passive forms of investing and track an index and endeavour to deliver you the returns similar to that of an index. While choosing between the two, there are a few parameters that may be of relevance. One is cost - on the cost front, ETFs have an advantage because you can get exposure to an index for as low a cost as just five-seven basis points. Index funds are also fairly economically priced, with a direct plan costing about 10-15 basis points. While ETFs have an advantage, index funds do not lag on that front by a wide margin.

Second important factor is the liquidity of these funds. In case of index funds, liquidity is not an issue because the fund companies stand committed to honour your redemption request on any working day at the prevailing NAV. But in case of ETFs, liquidity may not be the same across all funds. For retail investors, the viable route to exit an ETF is by selling them on a stock exchange, just like an equity stock. So for ETFs, you have to check the trading volumes it is able to generate and whether those trading volumes are good enough for your scale of investment - if you were to exit this fund, will you be able to conveniently do that, given the trading volumes of the ETFs.

Moreover, investors who otherwise do not invest in stocks and therefore do not own a trading or a demat account find it much more convenient and hassle free to invest in index funds because it saves them from the effort of opening and maintaining a demat and a trading account. But investors who do invest in stocks as well, for them ETFs can also be a viable option. So those are the kind of considerations one can keep in mind while deciding which fund to opt for.

To answer the second question about which index should you choose to buy an index fund, I would say, you can look at funds which are tracking either the Nifty or the BSE Sensex, because in this kind of a segment, you have plenty of good and efficient ETFs and index funds which come at a fairly low cost. There are a few index funds available which also track the mid-cap index. But the point is that the investment case for passive investing in the mid-cap segment is much weaker at the moment and also there could be issues around the replicability of the index as the size of these funds grow. So for now, I would suggest, one should stick to the funds tracking the Nifty or the Sensex as far as passive investing is concerned.

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