Investors are always looking for simpler investment solutions and not ones that have complexities. This way, they can track their investments in a simpler fashion rather than spending too much time following up on their investment decisions. Such investors can adopt a passive investment strategy by investing in schemes like passive mutual funds. For those who aren’t aware, mutual funds can be broadly classified as actively managed funds and passively managed funds. Actively managed funds are those mutual fund schemes that have active involvement from the fund manager who along with a team of expert analysts and market researchers take investment decisions on behalf of the mutual fund scheme. And then there are passive funds that are designed to mimic the performance of their underlying benchmark.
Exchange traded funds (ETFs) and index funds are two such passive funds that adopt a simple investment strategy. However, the question lies in whether you should invest in an ETF or go with index funds?
To determine which passive fund is ideal for the financial goal you need to get to know each of them in a better way.
What are exchange traded funds?
An exchange traded fund is an open ended mutual fund scheme that is listed at almost every stock exchange and investors can buy / sell its units just like company stocks. An exchange traded fund comprises several securities and is designed to mimic the performance of its underlying benchmark with minimal track error. Unlike other mutual funds that try to outperform their underlying index, exchange traded funds aim at generating capital appreciation by replicating the performance of their underlying index. ETFs can be traded at their current live market price during live trading hours. Investors need not wait for an ETFs NAV to be determined at the end of the day. Instead, they can enter or exit ETF investments end number of times throughout market hours.
What are index funds?
Index funds are those mutual fund schemes that imitate the stocks of a particular index like the NIFTY50 or SENSEX30. Since these are passive funds like ETFs, the fund manager invests in the same stocks in the same proportion as they exist in the underlying index without changing the composition of the portfolio. However, since index funds cannot be traded at the stock exchange, investors need to not have a demat account to invest. They can invest in index funds using their regular mutual fund account. Since these funds cannot be traded at the exchange, investors can buy or sell the index fund units by placing an order to the AMC and can trade at their NAV which is determined at the end of the day.
One similarity between these two funds is that an investor can start a monthly SIP in both these passive funds. For those who aren’t aware, a Systematic Investment Plan or SIP is an investment tool that lets retail investors invest a predetermined sum periodically in mutual funds.
Difference between ETFs and Index Funds
Both ETFs and index funds follow a passive investing style. However, to invest in ETFs investors need a Demat account. Without a Demat account, investors cannot trade in ETF units. However, when it comes to index funds one does not need a Demat account. A normal mutual fund account is enough for someone to buy or sell their index fund investments. Index funds are not listed at the stock exchange unlike ETFs and hence, one does not need a Demat account. Index funds only attract expense ratio whereas ETFs attract expense ratio, transaction costs as well as annual fees for Demat account renewal.
To determine which mutual fund scheme is ideal for them, investors should consult a financial advisor.