ETFs and index funds

People often ask whether to pick an ETF or an index fund as if they were opposing bets. They are not. Both are ways to do the same thing — passive investing, tracking an index rather than trying to beat it — and the two can follow the identical index. What separates them is the plumbing: how you buy them, how they are priced, and what each costs to own.

The one thing they share

An index fund and an exchange-traded fund (ETF) both aim to mirror a chosen index by holding the same securities in the same proportions. Neither employs a manager trying to pick winners, so both carry a low running cost and both are judged on how closely they track — their tracking error. If two products follow the same index, the index is not the thing that separates them.

How you buy an index fund

An index fund is an ordinary mutual fund. You buy and sell units directly with the fund house at the day’s NAV, struck once after the market closes, with the cut-off time deciding which day’s NAV you get. You do not need a demat account, and you can run a SIP into it as easily as any other fund. It is the familiar machinery, with nothing extra to set up.

How you buy an ETF

An ETF trades on the stock exchange like a share. To buy one you need a demat and trading account, and you deal through a broker at a live price that moves through the day, not at a single end-of-day NAV. That makes an ETF quick to trade intraday, but it also means buying it is a market transaction, with the broker and the exchange in between you and the fund — and running an automatic monthly SIP into one is less straightforward than with an index fund.

Price: NAV versus market price

An index fund always transacts at its NAV, so the price you get reflects the value of what the fund holds. An ETF’s market price is set by buyers and sellers and can sit a little above or below the value of its underlying holdings — a premium or a discount — especially when trading in it is thin. Providers publish an indicative value through the day as a reference, but the price you actually pay is the market one, and on a quiet counter the gap between buy and sell prices can be wider than it looks.

How the costs differ in kind

The costs are different in type. An ETF often carries a lower expense ratio than a comparable index fund, but on top of it you pay brokerage, the usual demat and transaction charges, and the bid-ask spread each time you trade. An index fund carries its expense ratio and no per-trade cost to you. So a lower headline expense ratio is not the whole bill; which works out cheaper depends on how often and how you actually transact.

Which suits a regular investor

It comes down to how you invest. If you put money in monthly by SIP and would rather not hold a demat account, the index fund route is the simpler machinery and asks nothing new of you. If you already trade on an exchange and tend to invest in lump sums, an ETF can suit that habit. Neither is better in the abstract — they are the same passive exposure delivered two ways. H2 Investment is a distributor, not an adviser: this explains how the two differ so you can weigh them, and does not tell you which to buy.