The basic idea in both the cases of ETF and Index Funds is to mirror the index and give returns that are closely aligned to the index returns. Let us now study how are they different?
The ETF funds are more or less comparable to mutual funds in terms of their structure, regulation, and management. They function in a similar way to mutual funds offering diversified investment into various asset classes like stocks, commodities, bonds, currencies, options, or a blend of these. Some types of ETFs available to individuals are Equity ETF, Bond ETF, Currency ETFs, Gold ETF, CPSE ETF, etc. The ETFs can prove quite useful to those investors who demand focused exposure to a specific industry, asset class, region, or currency at a reasonable cost without worrying about researching specific industries. In addition to that, ETFs are also suitable as long-term holdings for ‘buy & hold’ investors due to low operational expenses.
Index funds are passively managed mutual funds, wherein the fund manager invests diversified investment into various stocks without changing the portfolio composition as present in the underlying index like NSE Nifty, BSE Sensex, etc. Index funds attempt to offer returns comparable to the index that they track. Hence, investors who prefer predictable returns and want to invest in the equity markets without taking a lot of risks prefer these funds. The fund’s manager of index funds does not change the composition of the portfolio based on his assessment of the possible performance of the underlying securities which he does for other funds managed by him. However, there can be a small difference between fund performance and the index. This is mentioned as a tracking error. The fund managers will try to bring down the tracking error as much as possible.
The biggest difference between ETFs and index funds is that the ETF shareholder directly trades his share like other stocks and books his profit or loss whereas, in index funds, the AMC makes profit or loss by regular trading of assets held by it and the investors in index funds can buy or sell only for Net Asset Value (NAV) set by the Funds at the end of the trading day.
Let us compare below the key difference between the two.
| Parameter | ETF | Index Fund |
| Portfolio | Where a pool of money is gathered from investors by an asset management company (AMC) to invest in various asset classes like stocks, commodities, bonds, etc. as the underlying. These assets mimic fractional shares of the index. | Where a pool of money is gathered from investors by an AMC to invest in shares, Bonds as the underlying designed to mimic the composition and performance of a financial market index such as BSE-Sensex, CNX-Nifty, or any other index that investors opt for. |
| Systematic investment plan (SIP) | Investment through SIP is not possible. Like a close-ended mutual fund, once the portfolio is created the fund does not accept fresh applications. You can only buy and sell ETF units through the stock exchange. | You can invest in a lump sum or systematic investment plans (SIPs) with the selected Mutual Fund |
| Demat account | You mandatorily need to have a Demat account. | Demat accounts are not compulsory to invest in index funds |
| Buying and selling | ETF units can be traded throughout the day like stocks. | The investor can purchase or redeem through AMC. The fund calculates its price for purchase or redemption of AUM at the end of the day at Net Asset Value (NAV). |
| Transaction Cost | A transaction fee is payable for the dealings both for buying and selling. | No transaction fee or commission is payable for purchase and redemption. |
| Recurring Charges | No recurring charges levied (Except Demat account’s annual maintenance charge and transaction charges which are restricted to under 5%. | A recurring charge is levied in the case of index funds in the range of 1% to 1.8% in the form of expense ratio*. |
| Liquidity | You can trade (buy or sell) throughout the day provided there is a counterparty to the trade | At any point in time, Index funds are open to purchasing and redemption at Net Asset Value (NAV) decided at the end of the trading day. |
| Dividends | Dividends are directly credited to your registered bank account. | You can opt for a growth plan where dividends are automatically reinvested. |
| Taxes | The dividends received to be added to overall income and taxed at your income tax slab rate. Capital Gain: LTCG – Not tax for capital gains up to Rs.100000. Any LTCG in excess of Rs.1 lakh will be taxed at 10% without indexation benefits (Section 112A of the Income Tax Act, 1961) STCG – As per Section 111A of the Income Tax Act, 1961, STCG is taxed at 15% plus surcharge and applicable cess. | The dividends offered are added to overall income and taxed at your income tax slab rate. Capital Gain: LTCG – Not tax for capital gains up to Rs.100000. Any LTCG in excess of Rs.1 lakh will be taxed at 10% without indexation benefits (Section 112A of the Income Tax Act, 1961) STCG – As per Section 111A of the Income Tax Act, 1961, STCG is taxed at 15% plus surcharge and applicable cess. |
* Expense ratio is the annual maintenance charge levied by mutual funds to finance its expenses. It includes annual operating costs, including management fees, allocation charges, advertising costs, etc. of the fund.
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