Mutual funds are a versatile investment avenue for wealth creation. Apart from various categories – equity, debt, hybrid, and others – and within them sub-categories, you also have the option of active funds and passive funds. Active funds are those where the fund manager actively pursues an investment strategy, as per the scheme's mandate, with the objective of generating alpha or outperforming the benchmark index.
Passive funds, on the other hand, such as index funds or ETFs (Exchange Traded Funds), simply replicate their underlying market indices. They are mandated to invest at least 95% of their total assets in securities that replicate a particular index. Hence, the investment objective is to generate returns that closely align with the underlying index.
Given this, the expense ratio of passive funds is less than that of active funds. According to legendary investor Warren Buffett, for most people, particularly retail investors, the best option is to own Index Funds or exchange-traded funds (ETFs). The reason is that these funds offer sufficient diversification and charge low fees/expense ratios (compared to active funds), making them ideal for long-term wealth creation.
In India, over the past few years, we have seen the rise of passive funds – equity index funds and ETFs – particularly after the COVID-19 pandemic.
So, let's understand the difference between index funds and ETFs in detail, even as there are similarities between the two.
Index Funds
As the name suggests, these funds primarily mirror the respective index, such as the Nifty 50, BSE Sensex, or BSE 500, or market-cap indices such as Nifty 100, Nifty Midcap 150, Nifty Smallcap 250, Nifty Large Midcap 250, Nifty Microcap 250, etc.
Today, you also have the option to take exposure to sector & thematic, such as the Nifty Financial Services 25/50 Index, Nifty Bank Index, Nifty Private Bank Index, Nifty PSU Bank Index, Nifty Auto Index, Nifty Consumer Durables Index, Nifty India Consumption Index, Nifty Capital Markets, Nifty Conglomerate 50, Nifty India Manufacturing, Nifty Services, Nifty Healthcare, Nifty MNC, Nifty Shariah, and so on.
Besides, there are index funds that replicate strategy-oriented indices, such as Nifty100 Low Volatility 30, Nifty 200, Nifty 100 Quality 30 Index, Nifty 50 Value 20 Index, Nifty Low Volatility 50, Nifty500 Low Volatility 50, Nifty Midcap150 Momentum 50, etc., which are also called factor-based index funds as their constituents are based on quantitative factors. In addition to index funds tracking domestic equity indices, there are funds tracking the S&P 500 Index, the NYSE FANG+ Index, the NASDAQ-100 Index, etc.
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Other than the equity index funds, there are debt index funds as well, tracking customised debt indices like CRISIL IBX 60:40 SDL + AAA PSU Index, Nifty G-Sec Sep 2032 Index, CRISIL IBX AAA Index, etc., with debt instruments across maturities and credit profiles.
So, depending on the investment mandate, the portfolio constituents of an index fund are weighted similarly to the index it tracks, and it essentially mimics the index's performance. The underperformance or outperformance, if any, is due solely to tracking error, which is the standard deviation of the difference between the portfolio's returns and its benchmark, and it occurs mainly due to management fees, transaction costs, and cash holdings.
The fund manager's involvement is limited to ensuring that the index fund mirrors the underlying index. Buying and selling are done only when there is a change in the index, and ensuring dividends, stock splits, or rights issues, etc., are adjusted in the fund's NAV to accurately reflect the value of the underlying index. A portion of the fund's assets is also held in cash & cash equivalents to meet liquidity needs, i.e. in case of redemptions.
As for expense ratio, it varies across index fund types – equity-oriented and debt-oriented.
For equity index funds, it is lower for market-cap-based index funds and higher (up to 90%) for sector & thematic and factor /strategy-based index funds. Debt index funds, in comparison, have a lower expense ratio. Whichever you choose, it is advisable to opt for the direct plan, which generally offers a lower expense ratio than a regular plan.
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How Can You Invest In Index Funds?
Index Funds can be purchased just like any other mutual fund: directly through the AMC, via an online mutual fund investment platform, or through your mutual fund distributor. Moreover, you can purchase index funds through SIP or lump sum mode.
The cut-off time for transacting is 3:00 PM on a business day for equity and debt index funds. Transactions done before this cut-off time will be at the same day's NAV, and if you miss it, the transaction will go through the next day's NAV (subject to realisation of funds).
Note, for SIPs (Systematic Investment Plans), cut-off timing is not applicable, since the investment is pre-scheduled. Your SIP order is automatically executed based on the fund mandate and payment realisation. However, delays in your bank's ECS/ACH payments or changes to the SIP date can affect which NAV is applied.
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Exchange Traded Funds
A key differentiating factor for ETFs is that they are traded on the stock exchange. Hence, ETF units can be bought or sold at the prevailing real-time NAV throughout trading hours, just like stocks. Just like index funds, there is a variety of ETFs. Among the Equity ETFs, those tracking/replicating the Nifty 50, BSE Sensex, Nifty Next 50, Nifty 100, Nifty Midcap 150, Nifty Smallcap 250, etc., are among the most popular.
Then, you also have sector & thematic ETFs such as Nifty Bank ETF, Nifty PSU Bank ETF, Nifty IT ETF, etc., as well as the factor-based ones such as the Nifty 200 Momentum 30 ETF, Nifty 200 Quality 30 ETF, Nifty 200 Alpha 30 ETF, Nifty Alpha low volatility 30 ETF, etc. – just as the way you have index fund for these.
Likewise, there are ETFs investing in international markets, such as the S&P 500, Nasdaq 100, and NYSE FANG+, etc., that facilitate geographical diversification. Also, there are debt ETFs, such as the Nifty 5-year G-sec Index, Nifty Bharat Bond Index, Nifty CPSE Bond Plus SDL Index, etc., as well as commodity ETFs, such as gold and silver ETFs.
Compared to index funds, ETFs have lower expense ratios. The other advantage is that they offer better liquidity due to real-time pricing (since they are traded on the exchange), unlike index funds, where you transact trade at the day's NAV.
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How Can You Invest In ETFs?
All you need to buy and sell ETFs is a trading and demat account, and you can place the order on your mobile trading app, trading terminal, or by calling your broker. Depending on the demand and supply, an ETF price fluctuates. You need to ensure liquidity for that particular ETF before considering. The scheme discloses the closing NAV at the end of the day.
Usually, ETFs investing in popular indices, such as Nifty 50, Nifty Next 50, Nifty 100, Nifty Midcap 150, Nifty Smallcap 250, etc., have better liquidity.
In other words, ETFs offer convenience and flexibility to transact. That said, unlike index funds, ETFs do not offer the SIP option for investing. This is an impediment if you are looking to invest systematically and in a disciplined manner over the years.
Which Is A Better Option: Index Funds Or ETFs?
If you are looking to take the SIP route, index funds are a better choice, though their expense ratios are slightly higher than ETFs'. On the other hand, if you are making staggered lump sum investments or one-time and are conscious about keeping cost of investing low, then ETFs may be better for you.
What's important is choosing the right type of index funds or ETFs that align with your risk profile, broader investment objective, the financial goals you're addressing, and the time to achieve those goals.
Note that while passive investing does not involve the discretion of the fund manager when building the portfolio, don't assume it is less risky. The risk element shall depend on the asset class and the scheme's investment mandate. As regards capital gains tax implications, it depends on whether the index fund or ETF is equity-oriented or non-equity-oriented.
Choose your mutual funds thoughtfully.
Happy investing!
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