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Mutual funds have been steadily emerging as an attractive investment option for retail investors and have become one of the intelligent avenues to invest money. This is because it's convenient to invest in mutual funds, and there are many schemes to choose from.
Across different mutual fund schemes, the investment portfolio may be managed actively or passively. While active investing requires making active investment decisions by the fund managers, passive investing tracks benchmark indices instead of fund managers making independent investment decisions.
Passive investing may make the investing process relatively straightforward and transparent for investors, as benchmark indices are largely discussed and understood. It may be easier for investors to understand passive investment products as an investment option. Even from the risk management perspective, passive investment products aim to lower the overall investment risk for investors.
Investment risks can be broadly classified into two types: systematic and unsystematic. While systematic risk refers to unfavourable market events adversely impacting the investment portfolio, unsystematic risk may be specific to a particular sector or company.
When investors choose passive investment options, they rely on the broader market wisdom instead of betting on the investing strategies of the fund managers. This helps them eliminate the unsystematic risk from the financial plans, thereby mitigating the overall investment risk.
Index funds and Exchange Traded Funds (ETFs) are two investment options available to investors within the universe of passive investing. These funds track particular market segments by replicating underlying indices. While both these products may seem similar, there are some points of difference between them. Differences between Index Funds and ETFs are discussed below.
- Mode of investing
Index funds are no different from any other mutual fund scheme regarding the investment process. Hence, the investors may invest in an index fund by submitting the application form physically or through the website of the mutual fund house. They can hold the index fund investments in a Demat account or an investor folio. They can also invest via an asset management company's website or mobile application. In contrast, for ETFs, investors can invest in ETFs through stock exchanges or directly with the AMC in a particular lot size. Further, investors can hold the ETF units in Demat account only. - Transaction costs
Being passive investment options, index funds and ETFs carry lower expense ratios than managed mutual fund schemes due to lower fund management charges. Between the two, index funds don't imply any additional transaction costs apart from the scheme expenses, either at the time of investment or redemption from such schemes.
In contrast, investment or redemption of ETF units, if executed through stock exchanges, may incur charges as such orders carry specific transaction costs, including brokerage, taxes, exchange charges etc. Such transaction costs are levied on both sides of the transaction, i.e. buy and sell transactions. - Transaction price
Investors can invest in index funds through mutual funds only. The transactions through mutual funds happen at the daily Net Asset Value (NAV) declared by the fund house.
In contrast, ETFs can be traded through stock exchanges, with transactions happening at real- time prices and not the daily NAV. As such, the transaction price may happen at a price different than its prevailing market value, as the price of ETF units on the stock exchange is a function of the demand and supply of ETF Units.
The higher the gap between demand and supply, the higher the difference between the transaction price and prevailing market price, i.e., impact cost. Such impact cost directly impacts the investor returns and thus endeavoured to be maintained at lower levels. - Liquidity
Liquidity is not an issue when one needs to invest in index funds or redeem such funds. This is because the transactions in index funds are executed through mutual fund houses at the prevailing NAV. On the other hand, the liquidity may be lower for ETF units on stock exchanges, depending on the demand and supply of such units.
If there are no buyers for an ETF or fewer buyers for an ETF, an investor intending to sell their ETF investments may not be able to execute the transactions or execute such transactions at a lower transaction price.
While AMCs appoint market makers to create an additional layer of liquidity for ETFs by providing two-way quotes on the stock exchanges at all points of time, investors may face impact costs while transacting in ETFs.
So, while both index funds and ETFs enable the investors to achieve the objective of passive investing, the investors may choose between index funds or ETFs after considering the above points of difference.
Disclaimer-
To know about the KYC documentary requirements and procedure for change of address, phone number, bank details, etc. please visit https://www.utimf.com/servicerequest/kyc. Please deal with only registered Mutual funds, details of which can be verified on the SEBI website under "Intermediaries/market Infrastructure Institutions". All complaints regarding UTI Mutual Fund can be directed towards service@uti.co.in and/or visit www.scores.gov.in (SEBI SCORES portal). This material is part of Investor Education and awareness initiative of UTI Mutual Fund.