FundsIndia explains: Index funds and ETFs

What’s the difference between HDFC Nifty ETF and HDFC Index Nifty? Well, the first is an ETF and the second is a mutual fund. They both have the same purpose – that of mimicking the Nifty 50 index movement. Index funds and ETFs are similar in that they aim at delivering the same returns as a particular index or commodity – the Sensex, Nifty 50, Nifty Junior, Nifty 500, gold, and so on.

But the manner in which they do so, the methods in which you can invest in them, the way they operate, are starkly different.

Creation
An index fund is a mutual fund. The fund’s portfolio will be the exact copy of the index it is tracking and will change in tune with the index. To create an index fund, the fund house pools the money you invest and buys the same stocks as the index, in the same weight. For instance, a Nifty 50 index fund would hold the Nifty 50 index stocks in the same proportion of the index. A Nifty 500 index fund would have, yes, 500 stocks.

To start an ETF, the asset management company turns to players called authorised participants (individuals or institutions). These authorised participants will buy shares of the index the ETF will track. The ETF puts together these shares in the proportion of the index. It then breaks the entire thing up into blocks of a uniform value, called creation units, which represent the underlying index. Authorised participants receive creation units equivalent to the value of the stocks they delivered, based on the ETF’s NAV. The creation units are then listed on the stock exchange and are traded.

A gold fund is a mutual fund that invests in gold ETFs, since physical gold is not liquid enough for a fund house to buy, hold, and sell if required (to meet redemption requests). Nor is it practical!

Investments and redemption
You can invest or redeem your units in an index fund the way you would with any mutual fund. Either go through a distributor or invest through the fund house. All you need is a bank account and KYC compliance. To invest or sell an ETF, you need to necessarily have a demat and trading account.

Returns
Hark back to the first point. ETF units are listed. That means you are buying and selling an ETF at its market price, and not its NAV. Now, actual volumes traded will affect the ETF’s price. A mismatch between demand for ETF units and the actual supply of them from the authorised participants will result in a difference between the ETF market price and the ETF NAV (the NAV will move in line with the index). To prevent a gross mismatch, exchanges employ market makers to ensure that demand is, to an extent, met by creation units. In most cases, though, there will be a slight disparity and thus, your ETF returns and the index’s (or gold’s) return may differ.

In an index fund, you are allotted units on the NAV. As the NAV moves in line with the index, your returns will be similar. The difference comes in due to costs. The fund deducts running and maintenance expenses. Besides, it also needs to set aside some cash to meet redemption requests since it cannot simply sell stocks in its portfolio without upsetting the original proportion. This cash component will also cause a slight difference in the fund’s return. ETFs and index funds both pay dividends.

Costs
The immediate conclusion you can draw from the previous point is that an ETF won’t have these running costs. That is true. But remember that you will be paying brokerage on your ETF trading, just as you do with stocks. You will also incur annual demat account charges.

Suitability
Index funds and ETFs are useful for conservative investors who do not want to take on the risks of a fund manager’s ability to deliver market-plus returns. ETFs also serve additional purposes of allowing you to take advantage of short-term market movements by trading on them (more difficult with index funds as they are subject to cut-off times) and to hedge exposure through derivatives.

Variety
Most index funds and ETFs are restricted to gold and the bellwethers Sensex, Nifty, and Nifty 500. ETFs do however have a slightly wider variety. Apart from main market indices, you have ETFs based on the Nifty Quality 30, Nifty NV20, Nifty Dividend Opportunities, and Nifty Consumption, for example.

The concept of passive investing itself is quite new in our markets. The availability of, and knowledge about, different types of indices based on themes and strategies is also limited, unlike in global markets where ETFs are dominant.