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Over the last few years, mutual funds have become a popular investment tool. Lately, there has been a focus on index funds and exchange traded funds (ETFs). Although index funds and exchange traded funds look very similar, they differ in various aspects in the real term. In this article, we will discuss in detail the index fund vs ETF.

What is an Index Fund?

An index fund is a type of mutual fund where the portfolio replicates a stock market index (e.g., Sensex, Nifty, Bank Nifty, etc.) In other words, the mutual fund portfolio of index funds matches the constituents of the financial market indices. Also, these funds do not deviate from their benchmark index irrespective of the prevailing market conditions. 

Index mutual funds have low portfolio turnover, broad market exposure, and low expense ratio. These mutual funds replicate the portfolio of the benchmark, and hence they are also known as passive funds. Moreover, these funds are suitable for investors investing for the long term (10+ years) and those who do not want to monitor their portfolios constantly.

An index defines a market segment. In other words, securities that belong to the same market segment are grouped and form an index. These segments are either stocks or bonds. For instance, an index fund tracking NIFTY 50 will have the same 50 stocks that NIFTY comprises off and in the same proportion. The fund manager does not pick the stocks but just mimics the benchmark. The returns from index funds are more or less equal to that of the benchmark.  However, there would be a slight difference in the performance of these funds in comparison to the benchmark, which is known as the tracking error. Furthermore, these funds have a low expense ratio compared to actively managed funds.

What is an Exchange-Traded Funds (ETF)?

Exchange Traded Funds are a collection of securities that track an underlying index. In other words, the ETF portfolio matches the composition of an index in the same proportion. These funds consist of several types of investments: stocks, bonds, commodities, or a mixture of these forms. In other words, the ETF portfolio matches the composition of an index in the same proportion. Also, it is marketable security where it can be bought and sold easily. 

Unlike mutual funds, the price of ETFs fluctuates through the day. The value is determined based on the net asset value (NAV) of the underlying securities. Also, these funds are highly liquid and can be bought for a lower fee, making them attractive for individual investors. Furthermore, these funds merely track the performance of the index and hence are not actively managed by a portfolio manager. Hence, they do not attempt to outperform their respective index. 

Several types of ETFs are available for investors. They can be utilised for hedging, speculation, income generation or offsetting risk on their portfolio. Some of the different types of ETFs are gold ETF, bond ETF, currency ETF, commodity ETF, inverse ETF, sector ETF, equity ETF etc. Thus, the exchange traded funds are similar to mutual funds but are traded on a stock exchange. 

Index Fund vs ETF – Difference Between Index Fund and ETF

The following is the difference between the index fund vs ETF to help investors choose the better suited for their requirements.

Structure

The portfolio of index funds replicates the stock market indices. They do not have liquidity of their own. Thus, these funds have a higher number of assets in liquid securities and cash when compared to an ETF. As a result, there is a slight difference in the performance of these funds when compared to the actual index, which is known as tracking error. 

Exchange Traded Funds or ETFs are similar to mutual funds where the portfolio consists of stocks with the same composition of an index (like Nifty or Sensex). Also, these securities have the same weightage as they have on the respective indices. However, the portion of liquid assets and debt vary from one fund to another. Therefore, the returns from each ETF can also vary even if they are under the same index. 

Transaction

Index funds are your standard mutual funds, where the units can be purchased in the form of lump sum or SIP. Thus, it benefits the investors where they can automate their investment in these funds through SIP. Also, there is a disciplined approach to investments.

One can buy and sell ETFs only through a stock exchange for which the investors require a Demat account. Therefore, investors can purchase one unit of ETF through their Demat account via a broker. In other words, it is similar to the trading of equity shares in a Demat account. 

Pricing

For index funds, the purchase and redemption are executed at the end of the day at NAV. NAV is the net asset value based on the market value of all the securities held by a mutual fund scheme. 

The price of ETFs varies on a real-time basis. Thus, the prices also change frequently, like the stock market. 

Dividends

In index funds, the dividends are automatically reinvested in the fund when the investor opts for a growth plan.

On the other hand, since ETFs are traded like stocks, the dividends are directly credited to the registered bank account. 

Charges

The index funds levy a minimal charge in the form of an expense ratio between 1% and 2% (usually lower than other mutual funds). Additionally, the investors also have to pay a fixed transaction fee of Rs. 100 for every investment  above Rs. 10,000. Furthermore, if the investor exits the fund before the stipulated time period, the exit load is also charged. 

When it comes to ETFs, they do not have any recurring charges. They only levy a minimum transaction charge of 0.5%. Other charges like account maintenance charges that the investor has to bear are again very nominal.

Taxation

The taxation of index funds depends on the holding period of the units of the funds. Short Term Capital Gains (STCG) arises when the period of holding of the units is less than 12 months. The tax rate is 15% on the amount of gain earned. Similarly, Long Term Capital Gain (LTCG) arises when the period of holding of the units is more than 12 months. The tax rate is 10% without the benefit of indexation on the amount of gain earned. However, gains up to Rs 1 lakh are exempt in a year. 

The taxation of ETF investment varies based on the type of ETF. Capital gains taxation from Equity ETFs is similar to that of equity mutual funds. Where the holding period is less than a year, STCG is applicable at 15%. Suppose the holding period is more than a year, then a tax rate of 10% for gains above INR 1,00,000. On the other hand,  Gold ETFs and non-equity ETFs are taxable similar to debt mutual funds. STCG arises when the holding period is less than three years, where the gains are taxable as per the investor’s income tax slab rate. Similarly, LTCG arises when the holding period is more than three years, where the gains are taxable at 20% with indexation benefit. 

Settlement Period

The settlement time for index funds is one day.

The settlement time for ETFs is three days. 

Also Read Index Funds vs Mutual Funds

Conclusion

From the above discussion of index fund vs ETF, it is evident that both investment options have their own advantages and drawbacks. Also, both funds provide portfolio diversification at low costs. Therefore, an investor must conduct due diligence and select the fund that suits their financial goals, risk tolerance levels and investment horizon. 

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