ETFs or index funds? A lowdown on what's best for you

Exchange-Traded Funds, popularly known as ETFs, have always caught the fancy of investors, especially youngsters. But index funds are also equally appealing to them.

This piece aims to give clarity to those who are caught in a bind.

But first, we take a look at how they operate.

Funds that track a market index like the Nifty50 or Sensex are called index funds. When you invest in an index fund, you are investing in the entire index and not in individual stocks. These are passively managed stocks which means that the returns you get will be in a similar proportion to the market index, albeit slightly lower (because of the fees associated).

Index funds are built in a manner to have a similar performance to the market index they use. This means that if the Nifty50 index goes up, then your returns would go up, and if it fell, then so would your returns.

ETFs pool the resources of several investors to buy assets and securities, just like mutual funds. But the values of mutual funds can be decided only at the end of the day. With ETFs, the changes in their returns can be seen when prices fluctuate and they can be bought and sold anytime during the day.

Here’s a lowdown on their respective features:

— Index funds do not require demat accounts. They can be bought via banks or investment companies. On the other hand, ETFs require a demat account through which they can be bought and sold. However, they can be bought and sold through banks or investment companies as well.

— One of the major differences between ETFs and index funds are the costs that investors might incur with each of them. Exchange-Traded Funds charge a small transaction fee which is higher for an actively managed ETF. When index funds are traded as mutual funds they also incur an expense ratio that needs to be paid.

— ETFs are more tax friendly than index funds. Although both incur dividend distribution tax and capital gains tax, the amount charged for ETFs is relatively lower than index funds.

— ETFs can be bought and sold at any time during the trading hours of the day. Index funds, however, have to be sold through your mutual fund broker. If you exit a mutual fund before the stipulated time frame, there is also an exit load.

— Index funds are less volatile as they follow the trends of the benchmark indices. They are passively managed and hence there is less risk as compared to an actively managed ETF.