The Difference Between an ETF and an Index Fund

Do you know what mutual funds are? Well, they are no more complicated than pizzas!

Here’s how:

Let’s say you wanted to eat a small pizza, but all the pizzas on the market were huge. All the restaurants offered 25 piece options, but you only needed five pieces. And just like you, many other people in the market also wanted 1/5th the size of the pizza. So, someone had a great idea.

They started a company called Mutual Pizzas or MP. Mutual Pizzas would buy the big 25-piece pizza, make five parts of it, so that every part had five pieces each. Then MP sells those smaller pieces to the five people at a respective price. So technically, the five people bought the big pizza.

MP then had another idea. What if, instead of just offering five slices of the same pizza, they could also offer people different flavours. So they bought lots of different pizzas and made a combo pack with five different flavours in each pack.

But then they had another idea. They decided that some combinations would only have pizzas from the best restaurants in the market. Those whose names were on the top 50 list. They went on to make many such combinations based on different factors.

On the other hand, some people would buy one of the combos but later decide they did not want it. These people would then sell it to a buyer in the market. So the buyer bought the combo, not directly from MP, but from someone else in the market.

And this is what a mutual fund is like, where MP is the fund, the pizzas are the shares and the restaurants are the different companies whose shares are bought and sold.

The combination of pizza flavours from the top top 50 or top 30 list is equivalent to the index funds in the market where shares from indices like the Nifty 50 or the Nifty 100 are pooled together.

And finally, people buying and selling the pizza combos in the market is equivalent to Exchange Traded Funds or ETFs, where people trade their mutual funds in the market instead of buying them from the original source.

Now, let’s understand them better with the appropriate terminology.

What are ETFs?

As we discussed, ETFs or Exchange Traded Funds are very similar mutual funds with the main difference being that they are traded on the stock market like any other stock or commodity.

Here are ten things you need to know about ETFs.

1. These are multiple investment securities that are grouped together to form one asset and act in a similar way to mutual funds.
2. The different securities that make up an ETF include stocks, bonds and commodities, sometimes domestic and sometimes international.
3. Some ETFs may simultaneously hold stocks from different industries, while others may hold stocks from only one industry.
4. While mutual funds are only traded once a day after the market closes, ETFs are traded throughout the day, just like regular stocks, so their prices fluctuate according to the activity of buyers and sellers.
5. They can therefore be used to track an index, sector, commodity or asset based on what is in the basket.
6. ETFs offer more liquidity as they are traded on the exchange.
7. They are more economical as their management ratios are comparatively lower.
8. Broker commissions on ETFs are also lower than buying the stocks individually.
9. ETFs are used by investors to speculate, to hedge their portfolio, and to create income.
10. The different types of ETFs include Bond ETFs, Commodity ETFs, Stock ETFs, Currency ETFs, Inverse ETFs, Leveraged ETFs, Stock ETFs, and Industry or Sector ETFs.

Some of the popular ETFs in the Indian market are the Motilal Oswal NASDAQ 100 ETF, HDFC S&P BSE Sensex ETF, SBI S&P BSE Sensex ETF, Edelweiss Nifty 100 Quality 30 Index Fund and the UTI S&P BSE Sensex ETF.

What are Index Funds?

As we discussed earlier, Index funds are a type of mutual funds or even ETFs that tracks a specific index.

Here are ten things you need to know about Index funds.

1. Index funds are a type of mutual funds or ETFs that imitate an index such as the S&P 500 or Sensex.
2. This means that their portfolio consists of the components of the chosen index so that they can replicate its composition and behaviour.
3. These provide broader market exposure than investing in just one asset.
4. Index funds use a passive fund strategy where assets are chosen based on the index and the fund manager does not have to actively track the market to make changes to the portfolio.
5. Changes to the portfolio are only made if the benchmark index changes, or to change the weightage of certain securities so that it continues to mimic the index.
6. As a result, Index funds have lower fees and costs than actively managed funds and low portfolio turnovers.
7. Index funds are fruitful for buy-and-hold type of investors as they offer long-term returns.
8. This makes them an apt choice for retirement accounts.
9. However they lack flexibility and human involvement.
10. They can also be vulnerable to market swings and downturns.

Some of the popular index funds in the Indian market are the Nippon India Index Fund - Sensex Plan, LIC MF Index Fund Sensex, ICICI Prudential Nifty Index Fund, UTI Nifty Index Fund and the Franklin India Index Fund Nifty Plan.

What is the difference between an ETF and an Index Fund?

Let’s do a recap and understand the differences between an ETF and an Index Fund.

ETFs	Index Funds
Operates more like a stock.	Operates more like a mutual fund.
May be actively or passively managed.	Mostly passively managed.
Offers short-term gains as they are regularly traded on exchanges.	Offers long term gains as they are often bought-and-held.
Are bought in units and their multiples, just like stocks such as 5 units, 10 units, etc.	Are bought in terms of amounts like ₹500, ₹1000, etc.
Offers relatively more liquidity.	Offers relatively less liquidity.
As these are actively managed, there is a higher chance of tracking error.	As these mimic an index, there is a less chance of tracking error.
Price fluctuates daily according to the market.	The Net Asset Value is determined at the end of the day.

And that’s a wrap on ETFs and Index Funds. Check out the blog to learn more about these concepts, or comment and let us know what you would like to learn next.