Demystifying ETF and Index funds

27th January 2025

27th January 2025

Lot of investors get confused when they think of ETF and Index Funds. They feel both are same and generally not able to understand the fine difference that exists between them. In this piece, we try to explain the distinctions between each in a simple way to make the investors comprehend them.

INDEX FUNDS

Index Mutual Funds function by investing in stocks that emulate an Index like BankNifty, Nifty IT, etc. These are passively managed funds, in which the administrator invests in the exactly same securities as present in the corresponding index in the similar proportion and does not change the portfolio composition. This means the funds would give the almost equal return as that of the Index. This can be explained in an easy manner in the following way. An index is constructed typically using carefully selected stocks based on certain parameters like market capitalization or assigned equal weightage. For example, NIFTY 50 has 50 stocks under it with different weightages.

The following are the top 10 high market cap stocks in NSE Bench mark Index and their weightages.

These fifty stocks in nifty index with varying weightages add up to hundred. An index fund would invest in the similar proportion of stocks/weight as they represent the index.  As an example, if Reliance has 15% weightage in index the fund would invest fifteen percent of the portfolio in Reliance. By this, they mimic the return of the index. While an active performance oriented mutual fund aims to perform higher than  its underlying benchmark, an index fund, which is being passively managed, tries to match the returns offered by the underlying index. Hence, there is no pressure on the fund manager to actively manage it and it leads to lower costs.

As Index Funds try to track a market index, the returns are likely to match those offered by the index. Hence, investors who would like to have predictable and stable returns and have a long-term bullish outlook and want to invest in the equity markets without taking many risks, prefer these funds. In an actively investing and monitored fund, the fund manager scrutinizes the content of the portfolio based on his assessment of the possible performance of the  securities invested in the portfolio. This always adds an element of considerable risk to the portfolio. Since index funds are managed in a subdued manner, such risks do not arise. However, the returns will never be far greater than those offered by the actual return of the index. For investors seeking higher returns, actively managed equity funds with continuous rebalancing are a better option though there is additional risk.

EXCHANGE TRADED FUNDS

An Exchange-Traded Fund (ETF) is a specially designed simple investment vehicle for an investor. It is a version of mutual fund in whose units are traded on stock exchanges like shares. Like other types of mutual funds, the investors’ money is collected into a corpus, which is carefully invested in various securities to achieve a defined investment objective.

Majority of the ETFs worldwide are passive in the sense they follow the index. They replicate a market index, be it a stock index, a bond index, or a commodity index. In that sense, the ETFs try not to outperform the index but merely deliver index-like returns to investors before expenses.  As these funds are generally not active, their expense ratios are generally lesser than those of actively managed funds are. ETFs generally provide multiple benefits than open-ended mutual funds in terms of real-time price adjustments and low costs. Many small investors and professional investment advisors prefer ETFs to invest in an asset category or a market class.

 ETFs are perceived to be a highly cost-efficient solution for slow managed portfolios. The price per unit on the stock exchanges also closely resembles the actual real-time NAV, which predicates that the investor gets almost index-like returns continuously.

While the Expense Ratio of ETFs is lower, there are certain costs that are unique to ETFs.

Since ETFs are bought and transacted on the stock exchanges through a broker, whenever an investor makes a purchase or sale, he/she pays a commission for the transaction. Add to it, an investor may also incur additional STT and the regular costs of trading in stocks, including trading differences in the ask-bid spread etc. But it has to be kept in mind that traditional Mutual Fund investors are also paying the same trading costs indirectly, as the Fund pays for these costs.

ETF units are transacted exactly like stocks. Index funds, are priced only after market closings, but ETFs are priced and transacted continuously on the whole trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock.

Yet as their value is dependent on underlying index shares, ETFs entail the additional benefits of broader diversification and hedge than shares in single companies, as well as what many investors feel as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs typically trade at much higher volumes than individual stocks. High trading volumes reflects high liquidity, and it enables investors to get into and out of trade positions with minimized risk and cost.

Benefits of investing in ETF’s

ETFs provide the advantage of a diversified portfolio with the added simplicity of trading as a single stock. Investors may purchase ETF shares on margin, short sell shares, or hold for the long term as any other normal stock investor.

ETFs can be dealt and transacted easily like any other stock on the exchange through trading terminals across the country and the world.

Asset Allocation: Managing asset allocation can be difficult for individual investors given the costs and assets required to achieve proper levels of diversification. ETFs offer investors with open exposure to broad segments of the equity markets around the globe. They provide a range of opportunity and size spectrums, facilitating investors to build suitable investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both types, i.e. institutional and individual investors utilize ETFs to allocate their assets in a simplified economical way.

Investment Parking: Investors generally like exposure to equity markets, but often procrastinate to make investment decisions. ETFs provide a “Waiting Place” for cash that is earmarked for equity investment. As ETFs are liquid, investors can participate in the regular market while deciding where to invest the funds for the longer-term, thus avoiding potential costs. Historically, investors have used derivatives to achieve temporary exposure and small profits. However, derivatives are always fraught with danger. The large denomination of most derivative contracts can preclude investors, both institutional and individual, from using them to gain market exposure. In this case and in those where derivative use may be restricted, ETFs are a practical alternative.

Hedging Risks: ETFs can be used as an excellent hedging tool because they can be both borrowed and  shortsold to protect your portfolio. ETF’s are traded in smaller denominations compared to most derivative contracts and this makes them more amenable for risk exposure match especially for small investors holding small portfolios.

Arbitrage: Arbitrage trades can be done between cash and futures markets to make risk free profits. Here, ETF can be very useful to plan for arbitrage and do option strategies.  

DIFFERENCE BETWEEN AN ETF AND AN INDEX FUND

Both ETF and Index funds are mainly managed passively. However, index funds operate in a way similar to that of regular mutual funds in the sense that they would price at the end of the day based on the NAV of the fund. However, ETF is traded throughout the day like regular shares and this gives the opportunity for investors to add or exit the fund during crucial situations. Nevertheless, we need to have a demat account to trade in ETF, whereas Index funds can be bought directly from mutual funds without the requirement of a demat account. This makes it convenient for the investors to invest in index funds compared to ETF.

WHICH IS BETTER?

For an active investor who trades, hedges and times the market ETF would be a better option as he can track and do strategies which suits him. Whereas for a passive investor who does not track the market and ready for the long haul she might find it comfortable investing in an Index fund. Ultimately, the investor’s risk profile and investment horizon would decide his actions.

Discussion questions :

1. Is it possible for a lay investor to simulate nifty{index) returns by investing in stocks directly?
2. Explain the reasons for the lower cost incurred on Passive funds compared to active funds.