What is the difference between ETF and Index Fund

Mutual fund industry in India is growing like never before. In the last five and half years alone (since 31 March 2017) asset size of the Indian mutual fund industry has grown by three and half times. It has exhibited astounding CAGR of almost 27%. This shows how fast Indians are embracing mutual funds as an avenue to park their savings. This has also given mutual fund companies an opportunity to come out with different products. Two such products are Index Funds and Exchange Traded Funds (ETFs). Although, they are similar in nature, they differ in various aspects.

Index Fund

The concept of index fund differs from a normal mutual fund scheme in a way that instead of researching and selecting just those stocks that the portfolio manager thinks will outperform, an index fund buys all the shares that make up a particular index. For example, an index fund buys all the shares in same proportion that form part of an index such as Nifty or Sensex. These funds need to keep some funds in liquid market or cash to meet any redemption. The primary aim of index fund is to replicate the performance of its index. Currently, there are 40 index funds, most of them following Nifty or Sensex.

ETF

The idea of an ETF is similar to index funds. Therefore, portfolio of an ETF consists of stocks that form part of an index that the ETF is following. The weightage of stocks in an ETF is similar to that of its Index. Hence, if ETF is based on Nifty like Aditya Birla Sun Life Nifty ETF Fund, the portfolio of the fund will be same as Nifty and in the same proportion. However, some amount of the fund is kept in cash or liquid assets to meet any liquidity. But the proportion is lower than that in the index funds. Returns generated by ETFs are similar to the index that it follows.

Currently, there are about 51 ETFs following various indices, majority of them are following the bellwether equity index Nifty and Sensex. These funds are listed and traded on the exchange and to buy them you should have a trading and demat account. Very much like how you buy and sell individual shares. And therefore, you need to pay a commission and brokerage as you pay for buying and selling shares.  

Which one is for you

If you are a short-term investor who is willing to take advantage of the volatility in the market, ETF make better sense for you. However, if you are aiming to build a corpus to meet some specific financial goals, index fund is better. It also has the advantage of commission free purchase and an ability to reinvest a fund’s distribution back to new shares. Index fund suits to investor who believe in buy and hold strategy.