Passive Investments in India — ETFs vs Index Funds

What is a mutual fund?

A mutual fund is basically a security offered by an Asset Management Company (AMC). When you buy units of a mutual fund, the AMC uses the money to invest in a basket of assets (equity, debt, etc) which that on the mutual fund's purpose.

The price movement of these assets reflect in the 'Net Asset Value' of the mutual fund. The 'Net Asset Value' (NAV) is the price you pay to buy into the fund or sell units.

AMCs will charge you a certain percentage (expense ratio) to manage your money. This expense ratio is baked-in to the net asset value, i.e. the NAV is the current value of the holdings of the mutual funds minus expenses.

How do you transact with mutual funds?

Mutual Funds declare their NAV once per day. This is calculated at the end of the day.

When you purchase a fund before the cutoff time (typically around 12pm or 2pm) on any working day, you will receive units at the NAV price declared at the end of the working day by the AMC. Same goes for redemption. If your transaction is after the cutoff time for any working day, your transaction will use the NAV of the next working day.

For purchases, you typically pay when you make the investment and receive units on the next working day in your 'folio' (your account with the AMC). For redemptions, the redemption will reflect in your 'folio' on the next working day and you should receive money in your bank account within 2-3 working days.

You do not need a brokerage account to transact with an AMC. You need to be KYC compliant though.

The total number of 'units' of a mutual funds is not a fixed quantity. When you purchase a mutual funds, 'units' are created and when you sell, 'units' are redeemed / struck-off.

You can think of your folio as a ledger with the AMC. Each purchase or sale transaction is done in terms of units, and the ledger's 'balance' tells you how many units you currently own.

What is an index fund?

Index funds are passive mutual funds which track an 'index' like NIFTY 50 or BSE SENSEX. The AMC does not pick and choose where to invest, they will try to ensure their investments closely track the underlying index's composition.

Index funds are typically low cost (lower expense ratio).

Index funds cannot track the index with 100% accuracy. The gap between the performance of the index fund and the performance of the index is called as a 'tracking error'.

The fund's expense ratio also contributes to the fund's tracking error. Higher expense ratios will increase the 'cost' of the fund for you and this should shows up as a higher tracker error over time.

What is an ETF?

ETFs (Exchange Traded Funds) are securities similar to a mutual fund which trade on a stock exchange (eg: BSE, NSE) just like other stocks (shares).

An ETF typically 'tracks' some underlying assets just like a mutual fund.

For the purpose of this post, we're considering ETFs which track an index — for example a Nifty 50 ETF.

How do you transact with an ETF?

Transactions with a ETF is just like buying / selling any stock in a stock exchange.

You need a brokerage account. At any time during market hours, you can put in a transaction to purchase shares of the ETF based on the currently visible price. You can place market orders or limit orders, or any other order types that the exchange supports.

These transactions are market transactions. When you purchase an ETF's shares on the stock exchange, there will be someone else who is selling it at the same time. The seller could be anyone — some other investor, some market participant etc. You will not purchase ETFs directly from the AMC or the entity which has set up the ETF.

The price for the ETF share is the price the market is willing to clear on any given order. This fluctuates depending on the market conditions. There is no single price for a day, and the 'closing price' at the end of the day can just be thought of as the price the last transaction cleared on.

The transactions execute immediately as long as the market is liquid, and settlement occurs using normal T+1 or T+2 settlement duration.

The ETF has a fixed number of shares at any given point of time, but this number can change as new shares are issued or existing shares are bought back by the AMC. Each share of the ETF represents a fractional ownership of the underlying assets of the ETF.

How does this ETF arrangement actually work?

ETFs need liquidity. If you go to an exchange and place an order to sell some ETF, if there is no one else who wants to buy it at the same time, your order will not go through. With limit orders, the market may have buyers and sellers but they may not have agreed upon a price.

To overcome this, there are designated Authorised Participants who provide liquidity in the market (they are market makers).

The authorised participants will be active on the market and provide liquidity by providing a bid/ask spread (quote a price for buying, quote a price for selling). Anyone who transacts on the exchange should immediately get matched to the authorised participant and the trade may immediately execute.

The authorised participants can work directly with the AMC to create or sell ETF shares to them.

What is the price of an ETF, really?

This is a complex system where you have the AMC, multiple authorised participants, and the investor.

The price that the investor sees on a stock exchange is the market price. There will be some (probably tiny) spread in the prices quoted for purchase / sale.

The authorised participants provide you with liquidity. They don't do this for free though, there will be a price for this liquidity that will ultimately be borne by the investors. (I don't understand this fully yet.)

The market price doesn't always match the Net Asset Value of the underlying assets owned by the ETF. It can be possible that you have a price on the exchange that is either lower or higher than the price of the underlying assets.

What this means is that your holding statement may quote one value, but when you sell the ETF you may get another value. In well run ETFs with a lot of liquidity, this gap will be tiny. If the ETF has few investors and low liquidity, there may be chances that this gap can be high.

During stressful market times when there is a lot of volatility, this gap may increase.

Basically, the price of the ETF is whatever the market determines, and may go out of sync with the actual value of the underlying assets. During times of uncertainty, if you need to sell your shares, you may have to sell them at a discount.

What do ETFs give you over a mutual fund?

With an ETF, you have liquidity and visible prices during the day. But does this really matter for passive investments in the long term?

If you are an active trader and you are planning intra-day strategies, this liquidity is very useful. But I would argue the liquidity is meaningless for a long term passive investor since you anyway get money after T+1 / T+2 day, and fluctuations within a day are not too important. Will you care about second by second price fluctuation of an ETF?

The second advantage of an ETF is often touted to be lower cost. For example, right now the expense ratio of Motilal Oswal's Nifty 50 ETF is 0.04%, but the expense ratio of their mutual fund is 0.10%.

This looks useful, but remember that for ETF you will be paying market prices instead. When you try to sell your ETF shares, the price you may receive can be lower than the underlying value. Liquidity comes at a cost.

Whether you will come out ahead with an ETF due to lower expense ratio is debatable, since it will depend on several such factors.

A ETF is fundamentally more complex than a mutual fund. If there are a lot of investors of an ETF, it should in theory be possible for you to come out ahead of a mutual fund, but the delta is tiny (0.05-0.06%).

I personally don't want to deal with a more complex product for such a tiny margin, especially because ETFs are not very common in India yet. Since ETFs are uncommon, they have low liquidity and higher volatility.

Also — ETFs can tempt you to look at minute-by-minute price fluctuations and try to optimise things. You might try to find the 'right' time to purchase or the 'right' time to sell. The mental hassle and the temptation to gamble is not worth it (for me).

One final difference — fractional units / shares

Mutual Funds let you purchase fractional units, since the bookkeeping is done by the AMC and they can assign you any number of units (even fractional). So you can purchase (or sell) nice round figures, you can quote your transaction in units or rupees.

ETFs trade on an exchange. You cannot buy a fractional share of an ETF. You have to purchase a whole number of shares. This means you cannot systematically invest a fixed amount each month, you have to invest either lower or higher based on what the price of the ETF is.

Basically, for mutual funds you can transact in terms of Rupees or units, but for ETFs you have to transact in terms of shares.

Why do ETFs exist?

I think one of the reasons ETFs were invented are taxation laws in the US.

Mutual fund taxation in India is simple. You only have tax implications (capital gains) when you sell a mutual fund yourself. Any transactions that the AMC does to maintain the fund do not affect you.

In the USA, this is more complex. Even if you have just buy and hold a mutual fund, you are liable to pay capital gain if the AMC sells some underlying assets¹. You may have to pay taxes out of your pocket even if you are just buying mutual funds long term.

ETFs allow you to dodge this tax event². With shares of the ETF, you are only taxed when you actually sell your shares.

So for Americans, holding mutual funds is more complex than holding an ETF. ETFs have a large advantage.

This does not apply to India though. The rules of taxation are different, and ETFs don't have an edge over mutual funds in this regard.

Overall conclusion

This post was mostly focused on equity, not debt.

I ended up with the conclusion that mutual funds are the way to go for me personally — I'm avoiding ETFs and sticking with direct, index mutual funds.

I might end up changing my approach in the future when ETFs become more popular / more mainstream. At present they feel like a niche solution to a problem that does not exist in India.