Currently, passive investing is not popular in India, as most actively managed funds have beaten their respective benchmarks. However, as the market matures, it may be difficult for fund managers to generate alpha.
Just as actively managed funds can be segregated into different types, passively managed funds are of two types: index funds and ETFs.
Though both of them replicate the underlying index, there are some basic differences between both of them. We spoke to few experts to find out which one is more suitable for retail investors.
Liquidity: Units of index funds are priced at the end of the day after business hours just like a mutual fund. However, in case of ETF, the price of the ETF units keep on fluctuating depending on the number of transactions.
Suresh Sadagopan of Ladder7 Financial Advisories recommends index funds to retail clients as investors do not have to worry about finding a buyer or contacting the fund house when they need to sell their units. He says that investors should be careful while choosing an ETF as liquidity may be an issue with a few fund houses.
Another factor that makes index funds more suitable for retail clients is the impact cost associated with ETFs. If the trading is less in an ETF, the bid-ask spread widens which raises the impact cost for both buyers and sellers. On the other hand, there is no impact cost for index funds.
Impact cost is the cost that a buyer or seller of ETFs incurs while executing a transaction. For instance, if investors sell 300 units of ETFs, the first 100 units will be sold at the market price compared to other 200 units, which will keep on decreasing due to demand constraint.
Expense ratio: ETFs have a lower expense than index funds. In most cases, the expense ratio of an index fund is 10-20 bps higher than the ETF. In fact, the expense ratio of a few index funds exceeds 1%.
From the TER perspective, experts recommend ETFs over index funds. "ETFs score over index funds as they have a lower expense ratio
ETF is better than index fund as there is no dent in returns for a long term investor. "Index fund is a common pool account into which all investors pool their monies. Expenses are thus shared in a common pool, a genuinely long term investor in the common pool is penalised for the irrational behaviour of a short term investors who make frequent entry and exit into the fund. This does not happen in an ETF, a short term trader incurs his trading, brokerage and other costs, a long term investor who stays invested in the ETF does not get penalised
Wider choice: Vishal says that investors can build a portfolio through ETFs alone. There are many ETFs, which invest in benchmarks and specific sectors such as banks and pharmaceuticals. There are a few ETFs that invest in gilt and even commodities like gold
In addition, AMFI data shows that there are 54 ETFs as on September 2017 compared to 20 index funds.
Portfolio allocation: Index funds have higher exposure to money market instruments compared to ETFs. It is because an index fund can't be traded like an ETF. This leads to the difference in returns due to tracking error.
Let us look at it with the help of an example. As on September 2017, SBI ETF Nifty 50 has 99.9% allocation in equities whereas SBI Nifty Index Fund has 94.65% in equities, shows Value Research. Though both these fund track the same index, SBI ETF Nifty 50 has delivered 19.79% while the index fund has given a return of 18.76% over the last one year.
Demat account: As ETFs are similar to stocks, investors need a demat account to buy ETFs.
Index fund is better for retail investors, as they do not have to open a demat.
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