Investors can look at two vehicles for their index or passive investing i.e. Index Funds and Exchange Traded Funds.
First Index Fund (available for general public for investment) was launched by John Bogle in 1975. At that time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly”. Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor’s 500 Index. It started with comparatively meagre assets of $11 million but crossed the $100 billion milestone in November 1999. In India first Index Fund was launched in 1999.
The second option of Exchange Traded Funds (ETFs) had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes.
What are Index Funds and ETFs?
Generally, Index Funds and Exchange Traded Funds are passively managed funds that aims to replicate. Their job is to replicate the predefined rule based underlying index portfolio.
Let us understand this with an example. Let us assume there are three stocks in an index. Stock A, B and C. Weight of stock A is 50%, stock B is 25% and stock C is 25%. In this case if Rs. 100 needs to be invested, stocks A worth Rs. 50 will be purchased. Rs. 25 will be invested in stock B and balance Rs. 25 in stock C. Now if after a year this index gives 15% returns, the passive fund broadly will give 15% returns and if this index goes down by 15%, the fund’s NAV will also go down by 15%. However, due to fund-related costs and tracking errors, there will be little difference between index returns and fund returns.
Similarities and Differences between Index Fund and ETFs
Both are
regulated by SEBI
open ended mutual fund schemes
Less costly than active funds
Taxed like mutual funds as per underlying portfolio of equity or debt
Index Funds
Investment is made at closing values
Less cost efficient than ETFs
Do no require demat account
Only passively managed
Can be bought/sold through AMC
Exchange Traded Funds
Investment is made at real-time values
More cost efficient than index funds
Can be held only in demat form
Generally passively managed but can be active also
Can be bought/sold through Stock Exchange & AMC
Parameters to consider while selecting Index Fund and ETFs
Generally, investors consider only the stated cost i.e. total expense ratio of (TER) of Index Funds or ETFs and ignore other critical aspects.
Prudent Index Fund is combination of various parameters like TER, size i.e. asset under management (AUM), tracking error and tracking difference.
In addition to these parameters investors should also consider liquidity and trading cost while selecting an ETF.
Lower
Cost
Lower cost helps in enhancing the returns in the hands of investors.
Higher
Size
Higher size or bigger AUM helps in efficiently managing the fund and lower the cost.
Lower
Tracking Error
Tracking error shows how efficiently scheme is able to replicate underlying index on day to day basis. Lower tracking error is better.
Lower Tracking Difference
Tracking difference shows how much more or less returns scheme is generated than underlying index. Lower difference reflects efficiency of managing the scheme.
Higher
Liquidity
As ETFs are traded on exchanges, investors should evaluate volumes, bid-ask spread, variation of trading prices from real-time NAV of an ETF.
Lower
Trading Costs
As ETFs are bought/sold on stock exchanges, investor should evaluate tracing cost like brokerage, statutory and regulatory costs levied by exchanges, demat charges etc.
Selection Matrix Guidance