Index Funds vs ETFs, which is better for you?
Think of ETFs as a child born when stocks and index funds get married.
Nifty 50, the most well-known index from the Indian stock market, gave 14.9% CAGR in the last 20 years. What does this mean? If you had started investing ₹5,000 per month 20 years ago, you would have ~₹74 lakh now, i.e. you would have only invested ₹12 lakh, but your return would have been ₹62 lakh.
Maybe you did not start 20 years ago, but how can you start doing that right now? How can you start investing in an index that broadly represents the Indian Economy? Using either Index Funds or Exchange-Traded Funds (ETFs). Before taking this huge matter into our hands, let me briefly explain the difference between an Index Fund and an ETF.
First up, let's talk about ETFs or Exchange-Traded Funds. Think of them as a child born when stocks and index funds get married. They are a basket of stocks (just like mutual funds) that track a specific index (just like index funds) like the Nifty or Sensex. The big difference is that ETFs are listed on the stock exchange like individual company stocks. You can trade them like regular shares but need a demat account (of course) for that! Some common ETFs that track Nifty 50 are NIFTYBEES, SETNIF50, HDFCNIFTY, etc.
Index funds are similar in that they aim to replicate an index's performance. But instead of trading on the exchange, they work just like regular mutual funds - you can invest in them via apps like ET Money, IND Money, Groww, Coin by Zerodha, CAMS and KFintech websites, or even from the wesbite of the mutual fund. The most common Index Funds that track Nifty 50 are UTI, HDFC AMC, Navi, etc.
Both ETFs and Index funds are passively managed, i.e. the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. An investor does not want fund managers to manage their money, i.e., decide which stocks to buy/sell/ hold) but want the returns to mimic those from the index. In other words, there is no active involvement of the fund manager, so these instruments are passive in nature.
The most important feature of passive instruments is that they have crazy low expense ratios (fees) compared to actively managed funds – we're talking like 0.1% or even less! That tiny fee can mean a massive difference in your long-term wealth creation. Now that we have learnt the difference between the two, let’s see which is a better option for you. Not a difficult task, we just need to compare FOUR aspects from each side and we can easily figure out what is better for us.
Read this to know more about the concept of Expense Ratio.
Expense Ratio
There is no doubt that ETFs used to have very low expense ratio but not now. For example, the lowest expense ratio for any ETF in India is around 0.04% and for an index fund is 0.1% but recently Navi had launched their Nifty 50 index fund with an expense ratio of 0.05%. So basically, one of the parameters that used to an important part of index fund choosing strategy is suddenly become unimportant.
But one thing that people usually miss is that although ETFs have lower expense ratio on an average, it doesn’t mean their will give higher returns.
Clearly, a lower fee does not always mean a lower return. But why does that happen? It is due to the concept called “tracking error”.
You should read this to learn the concept of tracking error.
Both have similar expense ratios as of today, they both get 1 point each.
Tracking Error
If you google the tracking error for ETFs and Index Funds, you will find they are very similar, but that is misleading. The problem with ETFs is that the tracking errors are calculated based on NAV, but you are buying and selling ETFs based on the market price, so does it make sense to calculate the tracking error based on NAV?
NO.
So, the tracking error should also depend on the price. When you do that analysis (see the picture above), you will find that the price-based tracking error is ten times larger in the case of ETFs. Another issue that comes is that higher tracking error also doesn’t mean lower returns and it can easily be seen if you calculate it for some ETFs.
Summary:
Tracking errors and tracking differences for ETFs should be price-based, not NAV-based.
A lower fee does not mean a higher return.
Lower tracking error does not mean higher returns.
Index Funds are much better in this case as they are simple and easy to understand and generally have low tracking error, so the points are now Index Funds 2 and ETFs 1.
Liquidity
Liquidity refers to how easily you can convert an asset into cash without affecting its price. Cash is the most liquid asset, while real estate is relatively illiquid. If you are investing in just Nifty 50, Sensex, or Nifty Bank indices, then liquidity is not much of an issue. All these have large ETF markets , so it should be fine if you want to sell even large amounts.
But if you are investing in other indices like Nifty Midcap 150, Nifty Smallcap 250, etc, then ETFs might pose a problem since these are in relatively newer. In these cases, you might not be able to sell all of your holdings in a single day. In comparison, the mutual funds, on an average, take 2-3 days from withdrawal request to money coming into you bank accounts, so they have low liquidity.
On an average, ETFs are more liquid, so 2-2 for both.
Psychology
ETFs are a double-edged sword because they give you the flexibility to trade anytime during market hours, just like stocks. This "anytime liquidity" is a big attraction for some investors. However, there's a catch – since ETFs are so easily tradable, investors tend to sell them quickly when the market dips, missing out on potential long-term gains. So, if you're someone who might get tempted to sell at the wrong time due to emotions, Index funds are a better bet for you.
Again, index funds win here, so 3-2 in the favour of index funds.
Big Issue with ETFs
As I mentioned earlier, ETFs are traded on the stock exchange. Hence, the price of one unit of any ETF is determined by supply and demand. Most of the time, the ETF prices are never truly representative of their fair value because of several reasons affecting supply and demand. If you have started an SIP for ETFs, there is a high chance that ETFs are bought on the days when the premium (difference between actual price - and fair value) is high.
For example, recently (March - April 2024), RBI did not increase the limit on how much mutual funds can invest in foreign stock markets. After this news, many ETFs like Motilal Oswal Nasdaq 100 ETF, Invesco EQQQ NASDAQ-100 ETF FoF, etc, were trading at as high as 15-20% premium. If you buy them at such a high price, you will also see corrections that might take a long time for you to make good returns. That is why the actual tracking error is high in the case of ETFs.
However, if you do not invest using SIPs in ETFs and can regularly watch the markets, you can use this price difference to buy ETFs at low prices and sell at high and make profits.
What should investors do?
Avoid ETFs for long-term investment (trading is fine if you know what you are doing)
Choose a reasonably low-cost index fund with a low tracking error. Follow this guide to learn how to choose the best index fund.
You should always invest in a “Direct” fund, not a “Regular” fund. Check out this article to find out why.
To create massive long-term wealth, avoid huge churn, i.e. stay invested for as long as you can and it will surely help you. DO NOT TRY TO TIME THE MARKET!!
Stay focused, and do not get swayed by stock tips because it is harder to create massive long-term wealth using stocks. Read this to know why.
Share this article with your loved ones so that you all can start investing in the Index.
PS: This article should be considered as a starting point and the end point of your research. It could be that find ETFs better than Index Funds and the issues I have highlighted above do not matter so much to you. Take this article as my own opinion and experience.
DISCLAIMER: Mutual Funds are subject to market risk. Do your research before investing your hard-earned money. Please read all the scheme documents carefully before investing.
So so knowledgeable. Simple language, very understandable.
Thank you Lakshya, you are an ocean of knowledge.