What's with ETFs?

I said in the Index Funds article that there is another instrument that helps you mirror indexes, those are called Exchange Traded Funds or ETFs. So why are there two different instruments to achieve the goal of copying indexes? Read on.

The first major difference here is that you can trade ETFs like stocks. ETF units can be bought and sold like individual stocks in the market during trading hours. On the other hand, Index Funds can be bought and sold only at a price published at the end of each trading day.

Another big difference is that you can only buy ETFs on a per-share basis, meaning that if a particular itself trades for Rs. 105 per unit when you want to buy, you can only buy in multiples of 105. With Index Funds, you can buy for whatever amount you want. If an Index Fund has a NAV (Net Asset Value per unit) of Rs. 105, you can still buy for Rs. 5000, you would just be allotted fractional units, in this particular example, 47.61 units.

The next difference to note would be that Exchange Traded Funds generally would have a lower tracking error than Index Funds, which means ETFs would track the indexes more closely. This is mainly because Index Funds usually have to hold some cash to meet redemption requests. In the case of ETFs, the fund manager/management companies have no such obligation.

ETFs and Index Funds both have low costs than most mutual funds. While the expense ratio listed on Index Funds may seem higher than those for Index Funds, there are a couple of additional costs associated with ETFs. First is the commission charged by your broker and the second is the bid-ask spread in the market.

Now you can create a SIP with Index Funds, since these can be bought in terms of money, for example, Rs. 50000 every month. But with ETFs, you will have to manually buy units worth Rs. 50k when you want, since these can only be bought on a per-share basis, as stated above.

Choosing one over the other here depends on who you are as an investor. If you are a long-term investor that wants to follow a disciplined approach, then Index Funds are the way to go. But if you would like to time the markets as best you can, ETFs could be a better option, you could basically buy close to the day’s low of the day you want to invest to get that extra return too.

That’s it from my side on ETFs. Subscribe for free to receive new posts and support my work. And do let me know if you want a specific topic covered!

P.S. You can read all my articles here.