An investor looking to invest in an index has two choices,index funds or index Exchange Traded Funds (ETFs).
How are index funds different from index ETFs?
An index ETF is a hybrid investment vehicle that combines the features of mutual funds with stocks. An index fund operates and derives its characteristics wholly from a mutual fund. Even though both aim to mirror their respective benchmark indices, the manner in which they are traded is different.
Is the process of buying and selling of units different?
In an index ETF, units are bought from the fund house itself during the initial offer period. Investments that are made later are through the secondary market. In index funds, all units are bought and sold from the fund house itself at all times.
Index funds have a stipulated minimum investment which is usually Rs 5,000. However, investing in an index ETF is on the basis of each unit. Each unit of the index ETF is based on the value of the index at that point of time.
So this leads to the NAV of an index ETF being measured on a real time basis. This enables transactions to be executed on the spot, based on the price at the given moment. For index funds, the NAV is calculated at the end of the day. So, all investments in the index fund are made the next day.
Do the expenses differ?
Index funds charge their investors fees based on a percentage of total assets managed by the fund. Index ETFs have a lower expense ratio.The expense ratio in an index ETF ranges from 0.3% to 1% whereas an index fund’s ratio is between 0.3% and 1.5%.Since an ETF is listed on an exchange and is traded between investors via the exchange, the costs of distribution are reduced. ETFs also save on operational expenses such as custody costs and regular account statement expenses.
How do the taxes work out?
Both index funds and index ETFs attract capital gains tax of 15% if they are sold within one year of purchase. However, redemption of index ETFs attracts securities transaction tax of 0.125%, and for index funds, the tax is 0.25%.
What about SIPs?
Regular investing is possible through SIPs in index funds.Fund houses do not offer this facility in case of index ETFs. The common practice with index ETFs is that an investor instructs his broker to invest a fixed amount on a monthly basis.
The differences at a glance.
|
Features |
Index Funds |
Index ETF |
|
Minimum Investment |
Rs 5,000 (usually) |
Each unit is dependent on the value of the index |
|
NAV |
End of the day. |
Real time basis |
|
Expense Ratio |
Usually between 0.3% to 1.5% |
Usually between 0.3% to 1% |
|
Investments |
The fund house buys and sells the units at all times |
In the initial offer, fund house sells the units.Later, units are bought and sold on the exchange |
|
SIP |
Yes |
No |
|
Demat A/c |
Not Required |
Required |
What should you look out for?
Tracking error (the difference between the returns of the fund and the index) is higher in the case of index funds compared to index ETFs. In index funds, the money handed over by the investor is deployed in the fund the next day. But the units are allotted on the same day.In case of index ETFs, the money is deployed on a real-time basis. Another reason for tracking error is that index funds are required to keep some cash aside in order to meet redemption demands, which is not the case for ETFs, where new units are bought and sold amongst investors. Every ETF transaction will attract a brokerage charge.
Suitability of index funds and index ETFs
One advantage that index ETFs offer over index funds is that the investor can buy and sell at real time prices. Hence those looking at short term trading will prefer index ETFs.