Imagine you are an investor looking to build a secure future through long-term financial planning and wealth accumulation. You know that investing is essential to achieving your financial goals, but you lack the expertise or resources to actively manage a portfolio, or your schedule is too hectic. So how do you still capitalise on the potential growth of the market? The answer lies in looking into investing in passive investments such as exchange traded funds (ETFs) and index funds. 

AnETF is traded like a regular stock on the stock exchange. It holds a basket of stocks, bonds, or commodities reflecting the composition of the underlying index. An index fund is a type of mutual fund with a portfolio constructed to track or replicate the performance of an underlying index such as the Sensex or the Nifty.

Both investment options serve the purpose of tracking market performance while allowing investors to diversify their portfolios. However, they differ in management style, expense ratio, cost structure, liquidity, trading flexibility, and more. To help you make the right decision, let’s examine these two financial products in the mutual fund landscape and how they can fit into your investment strategy overall.

ETFs vs. index funds – Key differences to consider

• Pricing and trading

ETF prices are determined in real-time throughout the trading day, whereas index fund prices are only updated once per day after the markets close. This means that ETFs provide more flexibility for investors who want to buy or sell throughout the trading session. 

• Portfolio disclosure

ETF funds have a higher level of transparency as they are required to disclose their holdings on a daily basis. This allows investors to make quick decisions based on market movements and have an up-to-date snapshot of their investments. 

 Although index funds don’t disclose their holdings as frequently as ETFs, they still offer visible disclosures, typically on a quarterly basis.  

• Transaction costs/fees

Expense ratios are fees charged by the fund provider to cover the fund’s administrative and management expenses. Index mutual funds are generally known to have higher expense ratios compared to ETFs. However, these funds try to balance this out by incurring fewer transaction costs due to their buy-and-hold strategy. 

ETFs have more frequent trading activity, and each transaction (buying/selling) incurs a transaction cost, affecting investment returns.

• Tracking error

Generally, ETFs have no obligation to set aside any portion of their funds for liquidity purposes; thus, they can invest more fully into the assets that make up their target index. 

Index fund managers often reserve certain portions of their capital to ensure liquidity to buyers and sellers which can sometimes lead to higher tracking error or less accurate replication of its target index’s performance. However, technological advances have enabled many index fund providers to minimise this discrepancy significantly. 

Should you invest in ETFs or index funds? 

Both ETF and index funds provide diversification as you can gain exposure to entire markets with one purchase instead of buying individual securities separately. However, deciding which mutual funds to invest in should be based on your own financial situation, goals, and risk tolerance levels. Consider factors such as cost, performance, portfolio composition, liquidity, tax savings, and how long you will be investing.   

You can even include both ETFs and index funds in your investment strategy to get exposure to different asset classes and create a well-balanced portfolio for long-term growth.