Index Fund vs ETFs: What Are the Differences?

For mutual funds, there are two investment styles through which individuals can invest their money in the market. Namely, they are active and passive investment strategies. When investors choose to invest in an actively managed mutual fund, investors are handing money to a fund manager who will manage their investment according to their expertise. 

In passive investments, a fund manager creates a portfolio that mirrors indices like Nifty 50, Sensex, etc. ETF and Index funds are two popular passive investment options. This blog aims to cover the differences between ETF and index funds. 

What Are ETFs?

ETFs or exchange-traded funds are funds that are traded on stock exchanges. This means investors can sell their fund units to get profits instead of redeeming them. All ETFs track the performance of their respective indices. Thus, ETFs carry the features of both stocks and mutual funds.

It is similar to stock because it is tradable, and its prices fluctuate constantly. Investors who purchase an ETF can also set a limit order. These are highly transparent, and because of the transparency, investors will know exactly where their investments are allocated.

ETFs are also similar to index mutual funds because ETFs like Nifty ETF will track the Nifty index. This means Nifty ETF will have a composition similar to Nifty index funds, and the funds will be allocated in the same stocks. Moreover, the performance of an ETF will mirror its index. This investment option also invests its corpus on money market instruments to enable liquidity. 

Furthermore, the transaction takes place on a real-time basis, which is why it is affected by market conditions. Examples of exchange-traded are bond ETFs, industry ETFs, gold ETFs, liquid ETFs, etc. 

Also Read: What Are the Ways to Invest in the Nifty 50 Index?

What Are the Characteristics of an ETF?

A few common characteristics of ETFs are listed below:

• The total expense ratio of exchange-traded funds is very low, but they incur transaction charges.
• These funds are very similar to stocks and are traded daily, so investors need to create a demat account to invest in ETFs. 
• The dividends that investors receive from  ETFs can be reinvested into the market.
• Investors will get regular information about their portfolios if they invest in ETFs.
• Investors can buy or sell ETFs at any time without any limitations. 

What Are Index Funds?

Index funds are a passive investment option where the asset allocation is done such that it becomes a replica of the index it is trying to mimic. Fund managers do not select the industry or stocks to invest in. Instead, they purchase stocks and other instruments by following an index.

Index funds enable investors to invest in risky investments as it mitigates their risks by following the market. The fund manager’s role in an index fund is to ensure the investments do not fall from the benchmark.

Moreover, index funds generally trade replicating the popular indices like the Sensex or Nifty 50. Therefore, investors who want to create wealth over a longer period tend to invest in index funds.

Also Read: Equity Funds vs Debt Mutual Funds

What Are Some Characteristics of Index Funds?

The characteristics of index funds are stated below:

• Since index funds are a type of open-ended mutual fund, investors can redeem or invest at any time according to their convenience. 
• Fund managers maintain the fund units in an index fund on behalf of investors. Therefore, the fund manager has to maximise profit by replicating the index performance.
• Investors can invest as per their risk appetite for investments as there are a variety of index funds available replicating various indices.

What Are the Differences between ETF and Index Funds?

The following factors differentiate ETFs and index mutual funds:

What Are the Similarities between ETFs and Index Funds?

Now that you know the difference between ETFs and index funds let us learn about the similarities between the two passive investment tools:

• Low Fees- ETFs and index funds have lower expense ratios than most mutual funds because fund managers do not actively manage them. They do not spend efforts on research and analysis to outperform the broader market. The funds mimic the benchmark index. Since their total expense ratios are lower, investors can generate slightly higher returns than actively managed funds. 
• Long-term gains- Historically, it has been seen that passively managed funds perform better for long-term investments as compared to actively managed mutual funds on average. According to the S&P’s SPIVA report, 82% of active large-cap schemes underperformed the benchmark over a 5-year period that ended December 31, 2021. 
• Diversification- ETFs and index funds allow investors to diversify their portfolios. The investor will be exposed to numerous types of securities available in the market through these two investment options.

Moreover, the effect of market volatility on the fund’s performance is relatively lower compared to individual stocks. For example, if an ETF you invested your money in mimics the Nifty 50 benchmark, there is a high chance that your losses will be limited.

Read More: List of Best Index Mutual Funds to Invest in India in 2022

Final Word

Individuals who actively trade in the share market tend to invest in ETFs. If you are one of those people who prefer flexibility and want to buy or sell your investments quickly, you can opt for ETFs. Furthermore, ETFs are traded like stocks in the market, so you can use trading facilities such as margins, stop loss orders and limit orders.

On the other hand, if you choose to be a more passive investor, you can rely on index funds for long-term wealth creation. Moreover, you can invest in such funds via SIPs to make your investments more affordable. Both options are very similar, but knowing the differences between ETFs and index funds will help you make the right choice for your needs.

Frequently Asked Questions