Choosing between ETF and Index Fund

Stock markets have been rising relentlessly for the past few months on the back of central bank infused liquidity globally and the positive news flow on the discovery of Covid-19 vaccine. 

Stock indices such as the Dow Jones Industrial Average or the S&P 500 Index have hit record highs in recent times. Did you make your money work during the extended bull-run in the stock market the past many years, which only saw a temporary halt during the onset of the Coronavirus pandemic, or did you get left out as you were unsure of the stocks to pick or on your timing of entry?

Though it would be expected to feel morose at being unable to join the party, stock markets will keep giving you opportunities to make money at every point. However, if you are not good at stock picking or do not know much about the capital market, the best way to approach the market is to let your invested money be handled by experts who have structured vehicles through which they invest. 

Among the popular investment vehicles through which a typical investor can plow their money into various assets are Exchange Traded Funds (ETF) and Index Funds.

Even the most celebrated investor of all times – Warren Buffet – has advised a typical investor, who is not an expert in stock picking, to rely on Index Funds to generate wealth. 

For many years, Buffet has advocated investments in index funds over individual stocks as average investors run the risk of betting on wrong stocks and losing money in the long run.

While passive investing, where the fund manager’s discretion in making investment choices is limited, has caught up in most markets, investors are often confused if they should choose an index fund or its younger variant exchange-traded fund (ETF), which may also track an index?

Index funds decoded

First, let us discuss Index Funds. These are funds that mimic the chosen equity index by buying all the stocks in the same proportion present in the underlying index. An index fund’s objective is to generate returns similar to that offered by the underlying index, before expenses and tracking error, if any. 

Tracking error captures the gap between the portfolio construct of the index fund and that of the underlying index due to liquidity issues or the inability of the index fund manager’s inefficiency to replicate the index. However, in these funds, the fund manager’s effort is to keep the expenses and tracking error to the minimum. 

Index-funds are generally open-ended mutual fund schemes wherein the fund’s net asset value is announced at the end of the day. 

As an investor, you can buy and sell units of an index fund at the net asset value (NAV) subject to loads, if any. NAV is the per-unit value of the pool of assets minus liabilities of the fund in question.

In an index fund, the liquidity is assured. You can buy and sell the units at the NAV. But in the case of ETF, you have to be watchful of liquidity. Often there might not be buyers on the other side to provide you exit. Or the buyer may demand a price that is way below the NAV. In case you are buying the ETF units, there may be a situation that the seller may be asking for a premium to NAV.

Flexibility factor

Index funds provide you with ample flexibility to structure your investment pattern. You can invest your surplus in a lump sum, or you can also sign up for systematic investment plans (SIP) to benefit from dollar-cost averaging. 

In dollar-cost averaging, you invest the same amount of money at regular predefined periods to buy more or fewer units depending on the market’s movement. It helps you not investing all your money at high points and then lose out when the asset prices collapse. Instead, you may pick up more units when the market is down and thereby averaging your costs.

How ETFs work

Now let’s discuss ETFs. These funds are also a pool of assets, but their units are traded on exchanges like other instruments such as stocks. You can buy or sell ETFs at any time during the trading hours on stock exchanges. 

This is contrary to Index funds, or other mutual funds that can be bought at their NAVs declared post trading hours, subject to cut off timings.

An ETF can track an index or can actively manage a stock portfolio. Thus, an index fund may also choose to list the stock exchange units and let investors transact there just like they transact in shares. 

Here we have an ETF tracking a stock index. Examples of index funds and ETF on the same index would be the State Street S&P 500 Index Fund, which offers to replicate the performance of the S&P500 Index, and the SPY or SPDR S&P500 ETF is an ETF that tracks the S&P500 index.

An ETF can be a mutual fund scheme that is actively managed. It is just that you get to invest in it on a stock exchange.

Options galore

There are many variants available among ETFs tracking an index. Some ETF is backed by shares whereas some use stock futures to replicate the underlying index’s performance. Some offer leveraged exposure to an underlying index. 

For example, ProShares Ultra QQQ (QLD) ETF offers twice the Nasdaq 100 ETF’s daily performance. You can also ask for an inverse ETF. These ETFs tend to short-sell the underlying index and offer corresponding returns. If the underlying index falls, then these funds tend to go up proportionately. 

For example, SPXU –ProShares UltraPro Short S&P500 ETF offers thrice the short position on the S&P500 index. If the index rises by one percent, then this ETF fall three percent. If the underlying index falls one percent, then this ETF rises three percent. However, these more complex ETFs are generally for trained investors and best avoided if you are a long term investor.

Intra-day moves

You cannot take the benefit of intra-day volatility while investing in index funds. When the markets turn volatile, there are situations when the index may fall two percent intra-day but recover by the end of the day. 

Since the index funds operate on end-of-day NAV, there is no way you can take advantage of intra-day falls. But if you can place an order on the exchange when the index has fallen, then there is a fair chance that you get to buy ETF units at suppressed prices as the unit’s price tends to track the NAV of the unit at that moment.

There are advantages unique to each of these structures. You can choose one that works for you. However, if you are not clued on much to the investing universe and the products available, it is always better to consult a financial advisor who will help to invest your money as per your financial goals and risk appetite.