Investment
Passive investing has steadily gained popularity among investors looking for low-cost, market-linked returns without the risk of stock picking.
Products such as Exchange Traded Funds (ETFs) and index funds are designed precisely for this purpose, as they aim to mirror the performance of a market index rather than beat it.
While both ETFs and index funds track an index, the way they are bought, sold, and priced can be very different. Understanding these differences along with costs, liquidity risks, and return expectations is crucial before choosing between an ETF, an index fund, or an actively managed equity fund.
Here’s a simple breakdown of how these products work and which one may suit your investment style.
Exchange Traded Fund
An Exchange Traded Fund, or ETF follows a passive investment strategy where it seeks to replicate the index to which it is benchmarked.
As ETF units are bought and sold only on the exchanges, investors require a demat account and securities trading account to invest in an ETF. The investor has to pay the brokerage while buying and selling the units of the ETF.
An ETF will have a relatively lower expense ratio compared to a regular mutual fund scheme.
Story continues below Advertisement
In general, the traded volumes of ETF units in the exchanges are fairly low. Therefore, ETFs are subject to liquidity risk. There is a chance that the units of the ETF may not trade at the net asset value (NAV) due to the paucity of liquidity, which affects price discovery.
Index fund
A scheme tracking an index is termed an index fund. A fund manager is mandated to buy all stocks (components) of the index in the same proportion as they are in the index. The idea is to generate the same returns as the index before expenses and tracking errors.
Tracking error is the difference in the returns of the index fund and the underlying index. The index funds track popular indices such as Nifty, Sensex, Nifty Next 50 and Bank Nifty.
The fund manager of the index fund does not use his discretion while choosing the stocks in his portfolio and passively replicates the index.
An actively managed diversified equity fund has the potential to outperform the benchmark index if the fund manager gets his calls right. In case the fund manager picks stocks that end up underperforming, the fund lags the index.
Pros and cons of passive investing
Passive investing is popular because of a low-cost structure. The expense ratios of index schemes are much lower compared to those of actively managed funds. An index ETF may charge you an expense ratio of 10 basis points. An actively managed fund may charge 2 per cent or more. A lower expense ratio can add to your returns.
Index funds are free of fund manager risk. They offer market returns, and hence the investors can pick one with low cost and low tracking error.
Index funds vs. ETFs: Which one to choose?
Units of a mutual fund can be bought or sold through online and offline channels. Funds that are exclusively transacted on stock exchanges are termed exchange-traded funds.
If you have a demat account and can transact through a stockbroker, you should opt for an index ETF as they are one of the cheapest ways to invest , provided liquidity is good for the units of a fund.