Mutual funds: Know the difference between index funds & ETFs

Operationally, a passive fund may be in the form of an index fund where it is a usual mutual fund scheme as we know it, or an ETF where there is no purchase or redemption with the AMC but it happens on the exchange.

By Joydeep Sen

A passive fund is one where the fund manager does not take any active decision in the portfolio composition, but follows the index mandated for the fund. In case there is any change in the index composition, the portfolio of the passive fund changes accordingly.

Operationally, a passive fund may be in the form of an index fund where it is a usual mutual fund scheme as we know it, or an ETF where there is no purchase or redemption with the AMC but it happens on the exchange. In an ETF, the units are listed at the exchange and the purchases / sales in the regular course of business happens between investors. In certain cases, in ETFs, the purchase or sale can be with the AMC, in a minimum defined lot size known as creation unit.

Parameters to understand index funds and ETFs:

Execution
Units of ETFs trade on the exchange like equity stocks or other securities. You have to have a demat account and a trading account with a broker. Nowadays, everything is online, including trading on the exchange. There are mobile phone apps that facilitate trading in stocks, including ETFs. Index funds are like any other mutual fund scheme. You purchase from the AMC and redeem with the AMC. Nowadays this also is executed online. Paper-based / physical execution is possible, but in days to come it may become fully digitalised.

NAV and price discovery
In index funds, purchases and redemptions will be at the net asset value (NAV), i.e., there is no premium or discount on the NAV. In ETFs, depending on the demand and supply equation and the investors’ views on the underlying portfolio, trading prices in the secondary market may be at a slight premium or discount to the NAV.

In any MF scheme, NAV is published only once a day, late in the evening, taking into account the closing prices of securities in the portfolio. In ETFs, another level of price discovery can be built in, though NAV will be published in the evening only. In equity ETFs, where the underlying stocks are liquid, the implied real-time NAV, at the price prevailing at that point of time, can be disseminated on the website of the AMC. This will facilitate better price discovery for trading of ETF units during trading hours.

Trading in large lots
Index funds are purchased from and redeemed with the AMC. Since an AMC cannot place restrictions on withdrawals, the investor is assured of liquidity. ETFs are open-ended, when required, through the defined process, the corpus size of the fund can change.

When a large investor intends to dispose of a big lot and there are not enough takers in the secondary market, liquidity can be obtained, provided the quantum is of the size of the defined creation unit. The authorised participants mandated for the fund come into play, or the investor can approach the AMC directly. The AMC will extinguish units and provide cash in such cases.

Cost
While all AMCs charge expenses to the scheme, in ETFs the charges are relatively lower. There would be transaction costs for trading in the secondary market. Usually the costs are lower in an ETF, provided you do not trade too often.

Concentration
The rule that one investor can hold maximum 25% in a MF scheme is not applicable to ETFs. In an ETF there is no redemption with the AMC and usually, for lot sizes less than the defined creation unit, the secondary market is the only route for liquidity.

The writer is a corporate trainer (debt markets) and an author

INDEX FUNDS VS ETF
In index funds, purchases and redemptions are at NAV. In ETFs, depending on the demand and supply equation and investors’ views on the underlying portfolio, trading prices in the secondary market may be at a slight premium or discount to the NAV

In ETFs, purchases and sales happen between investors. In certain cases, the purchase or sale can be with the AMC, in a minimum defined lot size known as creation unit.