Index fund or ETFs? Compare total cost

The difference between market price and the NAV imposes an additional cost. Besides, there is brokerage fee, which amplifies an ETF's tracking error

The financial landscape in India is witnessing a notable shift with passive investing emerging as a favoured choice. At present, approximately Rs. 7.5 lakh crore, almost 25 per cent of the total equity and hybrid-equity asset under management (totalling about Rs. 31 lakh crore), is invested in these funds.
 

At its core, passive investing is a method where investors buy a bundle of stocks in the same proportion as in the chosen index. Take the example of the Nifty50 index, comprising India’s 50 leading companies represented in proportion to their market weight. Its movement mirrors that of its constituent stocks.
 

Those considering the passive investment approach can make use of two popular avenues: index funds and exchange-traded funds (ETFs). The differences between them can be explained using the Nifty50 index as an example.

Nifty 50 Index Fund: When an individual opts to buy or sell via an index fund, she approaches a mutual fund (MF) company. The MF then procures the 50 required shares and creates a fresh bundle for the investor. When the investor sells the index fund, the MF offloads these shares and hands over the proceeds to the investor based on the net asset value (NAV) at the end of the day. The MF charges a fee for the bundling and unbundling service called the expense ratio. Generally, index funds have a higher expense ratio than ETFs.
 

The index fund’s return lags behind the underlying index slightly due to the expense ratio. This difference in performance is termed tracking error. A lower tracking error indicates the fund’s performance is closely aligned with the index.

Decoding the Nifty 50 ETF: At the outset, the MF acquires the requisite shares, bundles them, and lists them on the stock exchange. Investors buy and sell ETFs directly on the exchange. Beyond the initial phase, MFs are not involved in bundling or unbundling, leading to a lower expense ratio in ETFs. Theoretically, this should translate into a lower tracking error for ETFs compared to index funds.
 

However, ETFs have additional costs. For instance, the market price at which ETF units are bought might exceed the NAV, while the price at which they are sold could be below it. In practice, an ETF’s tracking error, as measured by the closing market price, is far higher than if calculated based on its NAV. Other costs, such as brokerage, amplify the tracking error.
 

Take the Nippon India Nifty 50 ETF BeES (popularly called Nifty BeES) as an example. Its tracking error based on NAV over the past year stands at a mere 0.02 per cent, but this surges to 1.77 per cent when calculated against its closing market price. Meanwhile, the UTI Nifty 50 Index Fund (direct growth option) also has a 0.02 per cent tracking error, on a par with the Nifty BeES.

A common oversight among investors is to fixate solely on the expense ratio, ignoring other costs linked to ETFs (difference between market price and NAV, brokerage, and so on). Retail investors who buy and sell stocks might gravitate towards ETFs over index funds. Yet, it’s evident that index funds offer a lower all-encompassing tracking error. Moreover, ETFs don’t allow SIP (Systematic Investment Plan) mode of investment.
 

Truth be told, one wonders why retail investors opt for ETFs when index funds, with lower tracking error, are available. The trend in passive investing is likely to shift to self-balancing Fund of index Funds (FoFs), which include diverse asset 

classes such as domestic and international equity, debt, and gold. It’s worth noting that a hastily introduced tax amendment targeting debt funds has inadvertently affected FoFs. It is widely anticipated that this will be removed and index-based FoFs will play a pivotal part in passive investing in the future.


The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; Twitter: @harshroongta