Should you go for index funds or ETFs?

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Many of you have been asking us questions on investing in index funds or ETFs. The questions are broadly on these aspects:

  • Can I have portfolio with only index funds/ETFs?
  • How to add index funds to my existing portfolio?
  • What index funds or ETFs are available?
  • Give me a list of index funds with lowest tracking error
  • Are ETFs better than index funds as they have lower cost?

I’ve tried to provide answers to some of these questions here. Of course for the recommended list of ETFs or index funds, you will have to go to Prime ETFs or the passive funds under Prime Funds. You can also look at our MF Review tool to know whether the index funds of your choice are buys or sells (we have no holds in this category).

Please note that this is not an article for all index and ETF investing pros. Nor is it to debate on whether passive investing is the best strategy 😊 I plan to ignore any comments that lead to it.

This is to clarify the doubts many of you have: who are just starting to invest in index funds and ETFs and are using it for various goals, sometimes duplicating your portfolio, sometimes using it for SWP, and sometimes wanting us to calculate the total cost of your ETF.

 If you are a Prime Member (paid subscriber) and have any specific queries on our list of recommended products in passive investing, please write to us.

In this article, I have given links wherever key terms such as ‘tracking error’ or ‘bid-ask spread’ need to be explained. As there is already enough material on these, I will not be repeating it. Also, to know the basics about ETFs or index funds, you will find plenty of material online.

Part 1 – Index funds or ETFs? How to compare

Let’s tackle the question of costs at the outset. In our view, this decision is more a matter of convenience than merely a matter of costs. The reason why the answer is not a straight one is ETFs and index funds cannot be directly compared for multiple reasons. Let me explain why.

Total cost of owning an ETF

First, you would have noticed that the expense ratio of ETFs is far lower than that of index funds. However, take passive funds based on Nifty 50 as an example. The expense ratio of index funds (direct plan) come to an average of 0.2% while it is 0.08% for ETFs (as of May 2020). Most investors immediately conclude that ETFs are cheaper.

Prima facie, they are – but you need to look at the total cost of ownership (TCO) before arriving at a conclusion. Calculating the TCO is complex and not feasible unless a dedicated team (that works for institutional investors) does it. For example, the bid-ask spread may be tightly managed in an ETF that has high liquidity. It may not be in other illiquid ETFs. So, the costs can vary significantly.  

And above all this you need to really wonder whether a 12 basis-point difference in TER (total expense ratio of ETF and index funds and before the above-mentioned costs for ETF) between an index fund and an ETF can make a significant difference to your returns.

Tracking error

In its true sense, tracking error is the standard deviation of your ETF portfolio returns over the index returns. And ideally, your ETF portfolio returns should be net of the costs. Remember, in an index fund, all the cost is captured in your total expense ratio. Hence, the tracking error of an index fund over the index is a reliable number. In the case of ETFs, there are multiple layers of complexities.  

  • What you see as returns for ETF in many places is based on the ETF NAV and not the market price
  • Tracking error in most databases provide the deviation between the ETF NAV returns and the index and not the ETF market price returns and the index.
  • ETFs can declare dividend, either added as units or as cash. Hence, their NAV and market price will fall to that extent. So, how you compare them with index matters (TRI or just the index).
  • Also, comparing ETF returns (based on market price or NAV) directly with index fund returns may not also be correct due to the dividend component in ETF and the indirect costs you miss out in ETFs.

Let us give you a simple example with the Nifty 50 index funds and ETFs. The data below shows the tracking error for rolling 1-year returns (rolled daily to give 3-year data) of index funds and ETFs. To give leeway to ETFs (where dividend distribution happens in some cases) we took the Nifty 50 and not the Nifty 50 TRI. We took a stiffer benchmark for index funds with the Nifty 50 TRI.

On an average, the Nifty index funds fare well on tracking error.

But tracking error is not so simple with ETFs.

  • One, the high market price tracking error, it appears, is more on the upside. That is, the ETFs are delivering more than the index, especially in recent times. In months such as March 2020, ETFs fell far lower than the index simply because their demand held up their prices way above the index. Remember, ETFs such as the Nifty 50 and Nifty Bank are  used by derivative traders. While this is not necessarily a bad thing, it may not help you to buy an ETF whose price is supported primarily by high demand (which can fall later).
  • Two, on price deviations from NAV, the graph below will show you that it is evenly divided – i.e, Nifty ETF market price returns was more than NAV returns only half the time (using 1 year return rolled for 3 years). If you notice, market price returns are higher than NAV returns in recent times. This shows that there is higher demand for the ETFs. If you bought a Nifty ETF today, chances are that you will be buying it at a higher price than the NAV.

Liquidity and trading days

One of the biggest challenges in ETFs is in identifying ETFs with healthy turnover and which are traded steadily on all days. There are ETFs that may have healthy volumes on some days and no trading on other days. For example, the Nippon India ETF Sensex is traded just 67% of the days in the last 90 days, whereas the Nifty ETF from the same house does not have any such problem.

Not just that. The volume per se in some of the exotic ETFs are so poor that you cannot possibly be risking investments in them. For example, the NV-20, a value-based ETF suffers from poor turnover although the index is a high-performing one compared with other large-cap indices. While the highly liquid ETFs can have turnover of over Rs 30 crore a day, some of the ones we mentioned above have turnover as low as Rs 50,000 and untraded on many days!

So, liquidity and consistency in trading become 2 important factors when looking at ETFs.

Part 2 – Using Index funds or ETFs in portfolios

Now that you know the complexities in ETFs’ tracking errors and costs, why go for ETFs at all?

Why ETFs are looking interesting

To us, there are two reasons why ETFs have begun to look interesting compared with index funds: One, plenty of PF money and institutional money has created liquidity in some ETFs.

Two, with more factor-based indices coming up, there are more options in the ETF space than in index funds. There are 77 ETFs compared with just 36 index funds. And ETFs span market cap, thematic and strategy indices.

With this, let’s look at how to use ETFs and index funds as part of your portfolio.

Building a passive-only portfolio

  • If you are an investor who does not want to actively choose funds, worry about fund manager performance, review the funds or seek proper advice to maintain quality funds, then index funds or ETFs is the way forward.
  • If you want even less hassle, index fund is the better option, unless you have a trading account, know about ETFs and are aware of all that we mentioned above.
  • Do not choose index funds based on individual parameters. Some of you asked us for the lowest cost index fund. Remember, some indices by their very nature have slightly higher cost (of maintaining) than others. For example, a Nifty Next 50 index fund will have a slightly higher expense ratio than the Nifty 50 index fund. The question is about the suitability of a Nifty or Nifty Next 50 in your portfolio and not about the lowest cost across indices.
  • If you are still keen on ETFs, simply go with Nifty based ETFs with high volumes that we have provided in our Prime ETF list.
  • Avoid picking individual parameters alone to choose ETFs. A fund with low tracking error may suffer from poor volumes and vice versa. When we pick them, various metrics are weighted and then ranked.
  • We have both index funds in our Prime Funds list and ETFs in Prime ETFs. We have passive fund strategies, mixing indices to provide you a category-allocated portfolio. We build these by first putting a filter on the quality of indices – choosing those that have a higher potential of challenging active funds – and then looking at the fund parameters such as liquidity, tracking error, expense ratio and so on.
  • For debt, we would prefer that you continue to use active funds unless the ETFs have healthy volumes (like Bharat Bond ETF). We have written earlier that active funds offer sufficient options in the debt space.

Using passive funds in an active portfolio

If you are an active investor who is capable of handling an active fund portfolio, you can still complement them with passive funds; thereby reducing portfolio cost as well.

  • Where active funds are struggling to beat their indices or the index funds have unique propositions (example smart beta index or global index), then it makes sense to look at them to complement your portfolio with passive investing.
  • For example, with increasing evidence that large-cap funds are struggling to beat large-cap indices, there is a case for substituting them. Similarly, select smart-beta indices are showing signs of beating their parent indices. Our job is to help identify such options for you.

Some of you ask us why we have active funds at all, when index funds are beating them. The active options that we have are the ones that have been able to beat their benchmarks consistently (including the couple of large-cap funds we have).  Any underperformance would be short term and we keep tabs on them. In other words, we don’t provide active options unless the active management delivers superior returns.

As we are under no compulsion to ‘sell’ funds to you, our objective is to ensure you get optimal returns at lower cost.

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26 thoughts on “Should you go for index funds or ETFs?”

  1. Do you think for a layman, investing in NIFTY 50/ Next 50 Index and Midcap150 Index is better than active funds?

    Smallcap category still has many stocks and fund managers can outperform, but in the above 2 categories, it is becoming tougher by the day for the fund manager to outperform the index.

    1. We have written about it all in the blog. Not just for a layman, index funds do make sense for other investors too 🙂 Vidya

  2. @Vidya

    Is there is an liquidity issue with the ETF’s. Suppose I want to redeem major chunk of an specific ETFs on an given day, will I be able to do so. Or is it subject to buyers available ?

    1. Yes, the risk very much exists. That is why we pick the less riskier ones (and also provide alert when volumes aren’t great) in our ETF recommendations. thanks, Vidya

  3. Hello Vidya,
    I understand that Mirae Asset MF is launching a NFO called Mirae Asset Equity Allocator FOF which will invest in ETF of Nifty 50, Nifty next 50 and Midcap 150 in a certain proportion and re-balance it often. Did you get a opportunity to study this NFO ? Is it a good idea to invest in such a strategy? The idea is to move away from actively
    managed funds and start building a separate corpus using passive funds/ETF’s. Your inputs will be highly appreciated. Thanks. Vittal

    1. Hello Sir, Sorry I missed this. Yes, the NFO is interesting to the extent it used different ETFs. As long as the cost (we will know only when it is upa nd running) is reasonable, and tracking error isn not high, it will make sense. And unlike other FoFs a FoF that invests only in equity ETFs enjoys equity tax status. We will wait for some track record to see these metrics. thanks, Vidya

      1. Thank you very much for your reply. I think after all the latest fiasco with multicap funds, it is better to make future investments in Mirae equity asset allocater FOF or similar , one small cap Index fund, one International index fund and sit tight. I attended their call during the launch of the FOF and the TER is supposed to be 0.3 % including the underlying ETF. Thanks. Kind regards. Vittal

  4. Hello ,

    In the Chart “Index funds in India” , there is an * mark on S&P 500 TRI* and S&P BSE Diversified Financials Revenue Growth Index* . Any specific reason ? And Can I know the Index fund that tracks S&P BSE Diversified Financials ?

    1. Hello Sir, we’re sorry. That * denotes that it does not have open data source available locally. S&P 500 of US – Motilal Oswal has the international FoF. S&P BSE Diversified financials Revenue Growth – DSP BFSI NExt Inde fund was supposed to be the one but the AMC suspended/postponed the NFO. So thanks for pointing it out. We will update the data. thanks, Vidya

      1. There is no need for apologies and I should thank you Ms. Vidya Bala!! You articles make me delve deep , gets me into a thinking process. I read your reports like contract specifications in my workplace, as its carries so much information . The only difference is , I do this reading on weekends ^^

  5. Hi

    I have invested direct as per funds recommended in ready to use portfolio. Will it be a wise strategy to complement with 10-15% of overall investment as per your passive portfolio ?

  6. Very well written.

    In fact most people don’t realise that the “bid-ask” spread in ETFs itself has 3 different components to it. First the normal bid-ask spread that exists at the individual stock level. Second – the “bid-ask” spread for the lot size given the construction of the ETF. And third – the “bid-ask” spread to cover the market makers costs.

    ETFs in fact are one of the most misleading innovations in the equity in the last decade or so. They lack transparency at all levels.

    Also, what most people don’t realise is that these passive investments are basically disguised “momentum strategies”. Works well in a bull market or in a decade like the 2010’s. But have yet to prove their mettle in a decade which sees only see saw markets.

      1. Thanks Aarati and Vidya.

        Just to clarify a couple of points for people who may read my post.

        When I talk about the “bid-ask” spread, this impacts the NAV. And this is where the lack of transparency really hits the investor. People buy ETFs thinking the cost is only a few basis points. Not realising how much value is being extracted / given up in the quoted NAV itself.

        And the difference between the actual / market price and the NAV (to the extent the traded price is adversely positoned to the NAV) only further compounds the cost for the investor. Given issues like liquidity, etc.

        Another point to keep in mind is that all ETFs are not equal esp. across asset classes. For e.g. lot of people tried to trade commodity ETFs (e.g. USO in the US market) thinking they are trading the underlying commodity. Whereas the ETF actually had an underlying exposure not to the commodity but to derivatives. Same is true for several other commodity ETFs (e.g. gold, another popular one right now).

        Basically investors need to really carefully diligence the ETFs they are buying (as they say caveat emptor).

        1. Does a Fund of Fund channeling into an ETF mitigate any of these risks? Or will it only add another layer of expense?

          1. It mitigates the risk for a cost. So there is a ‘very marginal’ later of cost naturally. But it is significantly lower than active funds. Thanks Vidya

  7. Hello Vidya, Great article as usual. One more advantage in favor of ETF – they allow me to switch on the same day. For example, I can sell sell NIFTY BeES and buy Liquid BeES on the same day. For the same operation with Index funds, I need to wait for redemptions to reach my bank account on T+3 and then proceed to buy a liquid fund.

    Before someone says this should not make a major difference in a long term investment, it does matter quite a bit if you are implementing tactical asset allocation based on rules.

  8. Concise, Data backed and Insightful article comparing Index Fund and Index ETFs . Tough choice, but quite helpful , Vidya madam.
    Perhaps, an example with commitment time frames above 5 to 10 years would have helped make the choice easier

    1. Thank you sir. Portfolios and recommendations are available on the platform. The tracking errors are based on averages. Taking exampes for longer periods is difficult as most ETFs save for Nippon (erstwhile benchmark) have limited track record. Vidya

  9. Venkateswaran Muthukrishnan

    Thanks for this interesting article on passive funds.
    What do you think can lead to increased volumes on ETFs over the next few years? Are we moving in that direction to make ETFs attractive in India?

  10. Brilliant article Vidya
    This has given me new insights and answered several queries that I had in my mind. This will help me plan my investments better going forward.

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