Index Fund Vs ETF: Key differences between index mutual funds and exchange-traded funds

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December 17, 2020 12:21 PM

Index funds are passive funds where there is no role of the fund manager in the selection of stocks.

Index Funds, ETF, differences, mutual funds, returns, tracking errorAfter adjusting for tracking error and expenses of the fund, the index fund mirrors the returns that the index generates.

For those who wish to invest in mutual funds that carry lower charges, there are two options to choose from. One can invest through Exchange Traded Funds (ETFs) or choose to invest in index funds. Both of these variants are mutual funds but have certain key differentiators. While the units of ETFs are to be necessarily purchased and sold on a stock exchange, index funds can be bought like any other mutual fund scheme from the insurer’s website, financial advisor etc.

Index funds are passive funds where there is no role of the fund manager in the selection of stocks. In an index fund, the allocation and weightage of stocks is similar to that of the benchmark index. After adjusting for tracking error and expenses of the fund, the index fund mirrors the returns that the index generates.

So, with such a structure, whom does an index fund suit? For a new mutual fund investor, an index fund can be a nice starting point. It helps one to get familiar with the ups and downs of the markets and over time may consider other actively managed funds. The returns from an actively managed large-cap fund will depend largely on the fund manager’s call and therefore may either outperform the index or fall back. An index fund, also constituting large-cap stocks will, however, deliver returns in line with the market. If at all an investor need the fund manager’s acumen to work in his or her favour, opting for mid-cap fund along with the index fund could prove adequate.

An exchange-traded fund (ETF) is also a mutual fund scheme which can only be bought and sold on stock exchanges on real-time at prices that change throughout the day. An ETF scheme may not necessarily mirror any index but could be a portfolio of stocks representing an index such as S&P CNX Nifty or the BSE Sensex. There are several variants of ETF’s categories such as index ETF’s, Gold ETF’s, Sectoral ETF’s, Thematic ETF’s or even the Liquid ETF’s. Further, there are index ETF’s representing large and mid-cap stocks (Nifty and junior Nifty) thus giving an opportunity to create a diversified portfolio using ETF’s. To invest in ETFs, your existing Demat account used for buying stocks can come handy.

As ETFs can be bought and sold during trading hours on an exchange, the temptation to time the market could be high. Avoid any short-term moves especially when investing in equities. It is better to build an equity portfolio with a mix of schemes, that comes at low cost, by linking them to your long term goals.

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