Investments are an act of allocating funds into an investment tool. This action is done with the intention to earn extra income. This extra income can be used to take care of daily expenditures after retirement. While investing in mutual funds, you have two options for investments, namely, lump-sum and SIP. Apart from two investment options, there are numerous types of investments. One of those types is passive investing. This type of investing refers to an investment plan which is referred to as the buy-and-hold portfolio strategy. It comes with minimal trading in the market and is ideal for long-term investment horizons. Considered less complex and cheaper, over time, it may also produce after-tax results. Index funds and ETFs are considered the most prominent examples of passive investing.
Index funds:
Index funds are a type of mutual fund where a portfolio is constructed to match or track the components of a financial market index. Index mutual funds are known for coming with things like low operating expenses and low portfolio turnover. These funds make sure to track their benchmark index regardless of the state of the markets.
Exchange-traded funds (ETFs):
Similar to index funds above ETFs are known for tracking an index and thoroughly studying its performance by following the underlying indices for their performance. Also, these funds are a basket of funds, which is very much like mutual funds. However, they can be traded in the open market like individual stocks too.
While both of these might have a lot of things in common, there are some ways in which they differ. Please read below to learn to make the right choice between these two investment tools:
- Index funds vs ETFs: Fund management style:
While index funds are known for being passively managed instruments, ETFs can be both actively and passively managed funds. Under index funds, the fund manager allocates funds to instruments making up the index such as stocks and bonds. Though a fund manager may or may not invest in every component of an index, they do aim to get an appropriate sample of every piece so that the index performance can be tracked effectively over time.
Conversely, under exchange-traded funds, there is an investment team that researches companies and takes tactical decisions. These tactical decisions include things like how to build an ETF portfolio, which stocks to buy and which ones to sell, etc. Some of the active ETFs can be innovatively constructed. For example, it is possible to create an ETF that tracks and clones the portfolios of popular investors like Warren Buffett and Rakesh Jhunjhunwala.
Simply put, index funds are passive. However, not all ETFs are passive.
- Index funds vs ETF: Trading Style:
Index funds can be purchased and sold only at a price which is published at the end of each trading day. If you are investing with a long-term goal in your mind, the fixed price would not be bothering you.
However, if you are someone who is looking to time the market, ETFs are helpful as they have features like stop losses, intraday trading, order limits, and many more. From an operational perspective, exchange-traded funds resemble the workings of a stock. The reason is, that ETFs, very much like stocks, are traded on exchanges throughout the day. Hence, the price of an ETF keeps on fluctuating during trading hours.
- Index funds vs ETF: Liquidity:
Under index funds, the AMC proceeds to add your funds to its assets under management, i.e., AUM. After adding the investor’s share of money to the AUM, the AMC proceeds to buy securities that fall in line with the benchmark. Moreover, with index funds, the process of redemption is smooth. Therefore, liquidity is not a real problem under index funds.
ETFs on the other hand, are like any other equity share. Just imagine you want to sell 100 units of your ETF. However, if there are no buyers for those 100 units, you are stuck because you will not be able to sell any of your ETF units, especially at the price you want to sell them. This makes ETFs problematic from the perspective of liquidity.
Which one is better?
While ETFs are known for being very flexible, index funds are known for simplifying numerous trading decisions an investor is required and expected to make. Therefore, you should opt for index funds for your core holding.