ETF Vs Index Fund – Meaning and Where to invest?

ETFs and index funds are the two main avenues of passive investing. The popularity of passive investing has been on the rise in recent years. Passive funds include ETFs, index funds, and funds of funds (FoFs). The assets of passive funds have grown by over 400% in just 5 years, reaching Rs 6.36 lakh crore by 2022-end.

There are several reasons for the rise of passive funds, including their low cost, low maintenance, and wider suitability. One key reason is the underperformance of active funds. In 2022, nearly 67% of active large-cap funds underperformed the Nifty 100 index.

When it comes to passive investing, investors have the option of choosing between ETFs and index funds. Both track an underlying index and have their own pros and cons.

ETFs, or Exchange Traded Funds, can be bought and sold like stocks. They require a demat and trading account, and their prices can deviate from their NAVs. ETFs generally have lower expenses, with an average expense ratio of 0.07% for Nifty 50 ETFs.

Index funds, on the other hand, can be bought and sold like any other mutual fund. They don't require a demat account and have no price-NAV gap. The average expense ratio for Nifty 50 index funds is 0.22%.

To evaluate ETFs and index funds, several parameters can be considered. The expense ratio of ETFs is generally lower than that of index funds. ETFs also tend to have lower tracking errors, indicating better replication of the underlying index. In terms of returns, ETFs have performed slightly better than index funds, with an average 5-year return of 13.53% compared to 13.23% for index funds.

However, there are some caveats to consider. ETFs can have a price-NAV gap, where the price deviates from the NAV. This can be a disadvantage if the price is consistently at a premium. Liquidity is also a factor to consider, as low-liquidity ETFs can be challenging to buy and sell.

In conclusion, the choice between ETFs and index funds depends on the investor's preferences and requirements. ETFs can offer lower expenses, better tracking, and slightly higher returns, but they come with the price-NAV gap and liquidity considerations. Index funds are simpler to invest in and don't have these issues. Ultimately, investors should pick the option that aligns with their investment goals and strategy.