What is an ETF? Is it better than an index fund?

What is an ETF? Is it better than an index fund? | Vrid
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Heard many people mentioning ETF while talking about index funds or gold investments? Are they the same? How do they work? Is it riskier? Let’s discuss.

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In the past few newsletters, we spoke about what are mutual fundsindex vs passive and also discussed what is NAV? You can check them out.

Now, you would know that a mutual fund is a basket of assets. It can be equity, debt, gold, etc. A manager raises money from investors to invest in these assets and manages it for them for a small fee.

ETF is similar to mutual funds. ETFs will track a particular index, sector, commodity, or other asset. But as the name suggests, the exchange-traded fund is traded on an exchange just like stocks are.

Fund houses sell mutual funds outside the stock exchange. This is the reason you won’t be able to trade a mutual fund unit during the open hours of the market. 

Whenever you place a buy order for a mutual fund, the transaction takes place at the end of the trading hours after the NAV for that day is calculated. 

As ETFs are traded on an exchange just like stocks, you can buy or sell the ETF anytime during the market hours, and its price keeps fluctuating based on demand and supply.

Types of ETF

Most ETFs are passive/index. They invest in the benchmark index of the market, sector, etc. But there are a few active ETFs also available.

In India, we have

  • Equity ETFs that track Nifty, Sensex & other sectors
  • Bond ETF tracking government securities (G-Secs) and the Nifty Bharat Bond
  • Gold & Silver ETF tracking the market price of the commodity
  • International ETF tracking equity index of other countries

The Indian ETF market is in a nascent stage now. As demand increases, we expect a lot of more customised ETFs to be launched.

Important factors of ETF

The combination of passive management style, minor operations, exchange-trade, etc. leads to ETFs having low tracking and expense ratio compared to index funds.

As ETFs are traded like stocks, you have to pay transaction charges like STT, brokerage, etc. every time you buy or sell an ETF. 

Look at the below table that compares ETFs with an index fund.

Difference between ETF and Index Fund

Table comparing ETFs and Index Funds.

Things to consider before investing in an ETF

1. Volume:

Trading volume over a particular period allows you to compare the popularity of different ETFs; the higher the trading volume, the easier it may be to trade that fund. Avoid ETFs with low trade volume, as you may face liquidation problems. 

2. Expenses:

The lower the expense ratio, the better. But don’t look at this on a standalone basis. Take a decision after having a holistic view of other parameters. Because sometimes funds with a higher expense ratio may have strong enough performance that it more than makes up for the higher fees. 

3. Tracking Error:

Even though ETFs have lower tracking error than index funds, you need to compare the tracking error among the various ETFs available in the market. 

4. Performance:

Track the performance of the ETF over a 3, 5 and 10-year time period. While past performance is not a sign of future returns, this is a common metric for comparing ETFs. 

5. Spread:

Spread is the difference between buy and sell prices. Often because of liquidity, the spreads are very high. Be aware of the spread while buying or selling an ETF. 

Is it better to invest in ETF than index funds? 

On paper, ETFs look the best. The low expense ratio, low tracking error, easily traded, no exit load, etc. But in India, the ETF market is in its nascent stage. 

As of today, Most ETFs have low volume and AUM. They are mostly used for trading purposes. Therefore, their price keeps fluctuating, making it difficult to keep the investment simple for a SIP over the long term. 

So if you are looking to invest with SIP for the long term, go for index funds.  

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Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

ET Money – An Investor’s Guide To Exchange Traded Funds

Groww – Best ETFs in India

Forbes – Different Types Of ETFs In India

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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