InvestorQ : I am looking to invest in Nifty or Sensex as part of long term investment. Do you recommend an index fund or an index ETF?
Dawn Cherian made post

I am looking to invest in Nifty or Sensex as part of long term investment. Do you recommend an index fund or an index ETF?

Dilmini Mercia answered.
4 years ago

The choice will depend on a variety of factors and you first need to be familiar with the pros and cons of this decision. Consider these points.

In case of index fund, the total corpus would keep fluctuating. Here is why. Inflows into index fund add to the AUM of the Fund and outflows reduce the AUM. On the other hand, when you buy Index ETF it does not add to the AUM but only the units change hands like a normal share market transaction. Hence, liquidity is an important criterion in an index ETF.

You need to check whether you are comfortable dealing with AMCs or directly in the stock market. An index fund is available for purchase or sale based on EOD-NAV. Index ETFs are available to buy and sell during the trading hours at a price that reflects the Nifty fraction at point of time. This makes Index ETF more flexible as you can capture the volatility better.

Expense ratio in an Index ETF is much lower compared to the index fund. Just to take an example, if index fund has an expense ratio of around 1.00% then an index ETF would have an expense ratio of about 0.30%. But in addition, index ETF also entail brokerage and statutory costs to execute the trade. You need to consider that also.

Both Index ETF and Index funds only carry market risk (Beta) but there are 2 key risks you must be familiar with. There is the tracking error risk which is higher in case of index funds as they need to keep larger cash balances. On the other hand, Index ETFs run a higher risk of bid-ask spreads widening when markets get volatile and we have seen this in the past too; even for index ETFs and Gold ETFs.

The one area where SIPs lose out is the inability to do a regular SIP and that takes away the flexibility of the product. You can do automated SIP in index funds but cannot do automated SIPs in ETFs. SIP gives the added benefit of rupee-cost averaging which lowers average cost of owning the units. Since, ETFs are closed ended funds, SIPs are not possible.

On the taxation front, there is not much to choose between the two as the tax treatment is the same. Like in case of index funds, Index ETFs also are charged STCG at 15% and LTCG at 10% (above Rs.1 lakh per year). Such equity oriented funds are treated as equity funds for tax purposes. Holding period for long term gains is 1 year in both the cases.

To cut a long story short, there are two important criteria you need to consider when making the choice between Index ETFs and Index Funds. There is the cost aspect and there is the liquidity aspect. If liquidity is easily available in the secondary markets without too much of a basis risk, then lower costs will work in favour of the Index ETFs.