Varanasi Wealth Management：ETF Vs Index Fund – Meaning and Where to invest？

It’s no news that the popularity of passive investing is on the rise.

Take a look at the chart on your screen. It shows the assets of passive funds – ETFs, index funds, and funds of funds or FoFs.

At the end of 2018, the assets of passive funds stood at Rs 1.22 lakh crore. By 2022-end, they grew to 6.36 lakh crore, a jump of over 400% in just 5 years.

Now, there are many reasons responsible for the rise of the passives, including their low cost, low maintenance, and wider suitability, but one reason that stands out is their active counterparts’ underperformance.

A look at the percentage of funds underperforming the Nifty 100, Nifty Midcap 150, and Nifty Smallcap 250 indices will give you an idea.

As you can see, in 2022, nearly 67% of active large-cap funds underperformed the Nifty 100. For mid-caps % of funds underperforming was 55%. And even though just 13% of small-cap funds didn’t beat the benchmark in 2022, this number was quite high in the preceding two years.

So, underperformance by active funds possibly significantly boosted passive funds.

However, when it comes to passive investing there are two options available to investors – ETFs and Index Funds.

But, is one better than the other? If yes, then which one?

That’s exactly we will cover in this article. We will discuss key parameters you can use to evaluate ETFs and index funds, and also evaluate some of the most popular ones to see what comes out on top.

So even if you know the nuances of investing in ETFs and index funds, the in-depth analysis in this article will still give you some useful insights.

Alright, let’s start with a quick recap of the differences between ETFs and index funds.

ETFs and index funds are the two main avenues of passive investing.

Other emerging options are funds of funds or FoFs. A FoF puts money in another fund, which could be both active or passive. There could even be multiple underlying funds of a FoF.

However, from the perspective of how you invest, FoFs and index funds are similar. You can invest in both, as you would invest in any mutual fund.

So, mainly, we will talk about the difference between index funds and ETFs.

The table below highlights the key differences between the two.

Now, broadly, the difference between index funds and ETFs lies in the fact that index funds can be bought and sold like any other mutual fund.

But for ETFs, you will require a demat and a trading account, and you buy and sell them the way you buy and sell stocks.

ETFs and index funds track an underlying index, so they are similar here.

So, which is the better option?

Let’s see.

There are about 160 ETFs, 88 index funds, and 124 FoFs available. They are of various types. There are index ETFs/index funds, sectoral/thematic ones, international FoFs, factor ETFs and so on.

So, it’s nearly impossible to compare them all, and hence for our analysis, we will focus on the index funds and ETFs based on the Nifty 50.

You can use the framework we discuss to compare any other ETF and index fund you want.

We will look at factors that impact the performance of an index fund or an ETF. These include expense ratio, tracking error, the purchase price of ETFs, and their liquidity.Varanasi Wealth Management

So, let’s start. The first criterion is the expense ratio.

As we discussed earlier, one of the reasons for the popularity of passive investing is that the expenses are quite low.

So how do Nifty 50 ETFs and index funds compare in terms of expense?

We looked at the Maximum, Minimum, and Average expenses charged for this. As you can see, ETFs have a clear edge. They have average expenses of just 0.07% as against index funds’ 0.22%.

Now, ETFs look like a no-brainer when it comes to expense ratio, but there are trading costs associated with ETF investing that you need to keep in mind.

For example, on buying and selling Rs 1 lakh worth of ETFs, you have to pay Rs 239 as fees and duties. That’s around 0.24% additional cost. This is without the brokerage charges. So, depending on your plan, there will be additional brokerage costs.

Until around 2015, the average expense ratio on ETFs was about 60 to 70 basis points. Over the years, it has come down drastically. We saw a similar trend in the average expense ratio of index funds.

Now this is excellent news for investors, and it is happening because of the rising competition in this space. As more investors flock to passive investors, more AMCs have launched ETFs and index funds.

Alright, now let’s talk about the next parameter: Tracking error.

So, as we discussed earlier, an index fund or an ETF tracks an index. So you would want a fund that exactly replicates the index. If a fund falls or rises more than the index, it destroys the purpose of investing in an index.

How well the fund has replicated the index can be measured through a parameter called tracking error. If the fund behaves just like the index, the tracking error will be low. If a scheme is not doing a good job, the tracking error will be high. So, the lower the tracking error, the better.

The chart below compares the tracking errors of Nifty 50 ETFs and index funds.

ETFs have a lower tracking error on average, which suggests that they do a better job of tracking the Nifty 50 index.

Now, there are a few things that lead to tracking error. But mainly, there are three big reasons.

Let’s understand them one by one.

Tracking error is the most important parameter to look at when you are choosing an index fund or an ETF.

But we, as investors, are more interested in returns. So, let’s look at the difference in returns between ETFs and index funds.

If all schemes track an index, their returns should be similar. But that’s not the case.

Expenses and tracking efficiency differ for each scheme, and the two parameters directly affect the returns.

While it’s true that the difference would be small over long periods, even such minor differences can significantly impact your final corpus.

So, on your screen, you can see how Nifty 50 ETFs and index funds compare in terms of returns.

Here also, ETFs do well. Against an average 5-year return of 13.53% from Nifty 50 ETFs, Nifty 50 index funds delivered 13.23%.

So, given that ETF returns are better, they have a lower tracking error and expense ratio, they may look like a better option over index funds.

However, the story isn’t over yet. With ETFs, there are two important determinants: the price-to-NAV gap and the liquidity.

Let’s understand these two metrics as well.

As ETFs trade in the market, demand and supply often control their prices. This often results in their prices deviating from their NAVs.

This means the ETF price could be higher or lower than its NAV.

If the price is higher, you are actually paying more than what the ETF is worth.

If the price is lower, you are getting the ETF cheap.

But how big is this difference? Let’s take an example to help understand this. We looked at the SBI Nifty 50 ETF, the largest ETF on the Indian exchanges. It has assets of about 1.62 lakh crore as of June 2023.

Until about October 2022, this ETF had a price greater than its NAV. So, if someone invested in it around that time, they would have bought it expensive.

However, after that, the price has been at a discount. So, you are getting this ETF cheaper than what it is worth.

Is it a great thing?

Maybe. But if the price always remains at a discount, it may not be.

By the same logic, if the price always remains at a premium, it may not be a problem.

The problem will come if this premium/discount is significant. Or worse, if you have bought at a premium and now the ETF is selling at a discount.

Hence, you must assess the price-NAV gap of an ETF before you buy it.

If the price is at a premium to the NAV, it’s better to wait or simply buy any other ETF tracking the same index. You can very much buy an index fund as well.

Because index funds don’t trade in the market, they don’t face this issue. This is where they have an edge over ETFs.

Okay, what if you want to buy an ETF and you want to know its NAV at that point?

NAV is reported at day-end, so all you will have is the previous day’s NAV, which may not be the best guide if the index has moved significantly.

What to do, then? Thankfully, SEBI has got you covered. SEBI has instructed fund houses to publish iNAV or intraday NAV for ETFs. This iNAV can tell you what the actual worth of one unit of an ETF is.

You can find the iNAV both on the exchange and the AMC website. The image below shows the iNAV of SBI Nifty 50 ETF on the NSE website and the website of SBI Mutual Fund.

Now see the table below.

It shows the average one-year premium/discount to NAV of the available ETFs. It also shows the maximum discount or premium that a particular ETF showcased.

Some outlier values have been highlighted.

Given that the deviations could be really steep, do make sure you check the price-NAV gap before buying an ETF.

Let’s now come to the next parameter: liquidity.

In the stock market, liquidity means how easy it is to buy or sell a stock or an ETF. The higher the liquidity, the easier buying and selling an ETF is

Liquidity is not an issue with index funds as the fund house has to honor the buy and sell orders with index funds.

So, with index funds, you place a buy order with the fund house, and units are allotted to you.

You place a redemption request, the units are redeemed, and the amount is transferred to your account.

But with ETFs, you must be mindful of liquidity. If you somehow end up buying a low-liquidity ETF, you may find it challenging to sell it as there may not be a corresponding buy order at the moment.

To assess liquidity, we use a metric called volume. Volume is the number of units of a stock or ETF that is traded in a period. Or it can be the value of those units.

Take a look at the table on your screen. It mentions the available Nifty 50 ETFs and their average volume in rupees.

From about Rs 62 crore in a day to just Rs 80,000, the liquidity of the Nifty 50 ETFs varies widely.

So, if you want to invest Rs 1 lakh in Invesco Nifty 50 ETF, which has a volume of about Rs 80,000.New Delhi Stock Exchange

Similarly, selling Rs 1 lakh worth of this ETF would be difficult.

But if you want to buy or sell Nippon India ETF Nifty 50 BeES, it’s no problem at all. The order will go through like a breeze.

Another related point: the less liquidity, the more the gap between the price and the NAV of an ETF could be.

Why? Because a less-liquid ETF can show wild moves in price depending on the order size.

The same thing happens with less liquid stocks. If a large buy order is placed for such stocks, their prices skyrocket. If a large sell order comes, the price can tank.

So, while buying ETFs, be very careful about the liquidity.

Here, we have talked about just the Nifty 50 ETFs. These are expected to be the most liquid.

There are a plethora of other ETFs as wellBangalore Stock Exchange. There are sectoral ETFs, factor ETFs, thematic ETFs and so on. And many of them have very thin volumes.

As discussed earlier, index funds don’t have any such issues.

While ETFs have an edge based on expenses, returns, and tracking error, the situation gets complicated when the price-NAV gap and the liquidity troubles come into the picture.

Which should you invest in then: ETFs or index funds?

Let’s see.

So, ETFs or index funds?

I think the question itself is wrong. Let me rephrase it?

Which do you like better?

Did you say ETFs? You are right.

Did you say index funds? You are right too.

So, there is no right or wrong answer to this question. It depends on the investor.

Suppose you are comfortable operating a demat and a trading account and can assess ETFs for their price-NAV gap and liquidity. In that case, ETFs can save you money and get better returns than corresponding index funds.

However, if you want to keep it simple, index funds are the way to go.

As we suggested in the video on the differences between ETFs and index funds, you can even see them from the standpoint of investment horizon.

Index funds provide the SIP facility and are more suitable for long-term investors.

ETFs provide buying and selling during market hours and can be useful as tactical bets.

But this is not to suggest that ETFs can’t act as long-term investment instruments. You can do manual SIPs in them and today many brokers provide the SIP option as well on stocks and ETFs.

So, pick whichever suits your requirements better.

Whether you pick ETFs or index funds, invest regularly and keep a long-term horizon. Both are capable of getting you to your goals and creating wealth for your future.

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