ETF vs Index Fund: Which is a better investment option?

Highlights

• For risk-averse investors, Exchange Traded Funds (ETFs) and index funds could be a smart investment option to fetch healthy returns as these provide risk diversification.
• ETFs, like shares, are listed and traded on stock exchanges, which enables investors to invest in real-time net asset value. On the other hand, index funds are like mutual funds, valued at the end of the day.
• The root of ETF and index fund is indexing, which allows them to imitate the index benchmark. However, expense ratio, liquidity, tradability etc. are some of the essential differences to keep in mind before investing your moolah.

Investment in the stock market requires knowledge and basic understanding of its dynamics to avoid any financial malfunction.

There are many people who want to invest their surplus money in stocks, but fear of price fluctuations and uncertainty restrain them from leveling up and executing investment decisions.

For such risk-averse investors, Exchange Traded Funds (ETFs) and index funds could be a smart investment option.

Investors who have little time to follow the market trends can invest in professionally managed ETFs or index funds to diversify the risk and gain exposure to capital markets. However, all kinds of investment options possess some level of risk.

Also read: What do you Look for Before Investing in an Index Fund or an ETF? 

ETFs vs index funds: What’s the difference?

ETFs and index funds are based on the concept of indexing. In simple words, the fund manager maintains a portfolio in the same proportion and according to the underlying index.

Both are highly transparent as they strictly follow the chosen benchmark and cannot deviate from them. In other words, these funds mimic the underlying index.

1.    Difference in trading

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ETFs, like shares, are listed and traded on the stock exchanges, which enable investors to invest in real-time net asset value.

On the other hand, index funds are like mutual funds, valued at the end of the day. One can invest in index funds without any requisite for demat account.

2.    Difference in expense ratio

Fund managers charge some fees to look after the fund, which is generally lower in ETF than index fund.

Buying and selling ETF units, on the other hand, is subject to brokerage charges, which could make it a costly affair. Moreover, charges for trading account and its periodic maintenance also adds to the expense ratio while dealing in ETF.

3.    Difference in liquidity

ETF could be bought and sold freely in the exchanges, unlike index funds. However, it also means that demand and supply factors in the market result in price fluctuations, due to which you may find yourself buying an ETF unit at premium and selling it at a discounted price.

4.    Difference in tracking error

Index funds generally have some readily cash available in case of any redemption requests, which causes error in tracking the benchmark.

Meanwhile, as ETFs are traded as shares, there is no such obligation to have cash pile, which lowers its tracking error.

5.    The SIP route

Systematic Investment Plans (SIPs) are considered to be a disciplined way to invest where retail investors, instead of lumpsum money, engage in smaller and regular periodic payments (monthly, quarterly, etc.).

ETFs do not come with an SIP route, which could be a crucial factor to consider before investing.

Also read: 5 successful stock market strategies for newbie investors

In contrast, index funds are open to SIPs, often making them a preferrable investment vehicle for retail or small investors.

Which is a better investment option for you: ETF or index fund?

Investors who have the knowledge and understanding of stock market dynamics often prefer ETFs over index fund to make short-term gains.

On the other hand, index funds are known to simplify the investment process for newcomers, making it reliable venture to begin with.

The root of ETFs and index funds is indexing, which allows them to imitate the index benchmark. However, expense ratio, liquidity, tradability etc. are some of the essential differences to keep in mind before investing your moolah.