Investment Comparison: ETFs versus Index Funds - Definitions and Investment Opportunities?
In the world of passive investing, ETFs (Exchange-Traded Funds) have been making waves in India. At the end of 2018, passive funds, which include ETFs, index funds, and funds of funds, held assets worth Rs 1.22 lakh crore. By 2022-end, this figure grew to a staggering 6.36 lakh crore, marking a massive 400% increase in just five years.
The appeal of ETFs over index funds is evident. ETFs, which trade like stocks on exchanges in real-time, offer higher liquidity and flexibility. In contrast, index funds trade only once per day at net asset value (NAV). ETFs also boast lower expense ratios and better tax efficiency, reducing costs and improving after-tax returns.
Key factors driving this preference include trading flexibility and liquidity, lower fees, tax efficiency, access and convenience, and a variety of strategies. ETFs can be bought and sold throughout the trading day at market prices, enabling investors to react immediately to market changes. They also have lower management expense ratios and are more tax-efficient than many mutual fund index funds.
However, when comparing ETFs and index funds, it's essential to evaluate parameters such as expense ratio, tracking error, purchase price, and liquidity. ETFs, on average, have a lower tracking error, suggesting they do a better job of tracking the Nifty 50 index.
But the story isn't over yet for ETFs. They have two important determinants: the price-to-NAV gap and liquidity. After October 2022, the price of the SBI Nifty 50 ETF has been at a discount, meaning the ETF price was lower than its NAV. It's crucial to assess the price-NAV gap before buying an ETF, as if the ETF price is higher, you are actually paying more than what the ETF is worth. Conversely, if the ETF price is lower, you are getting the ETF cheaper than what it is worth.
SEBI (Securities and Exchange Board of India) has instructed fund houses to publish iNAV (intraday NAV) for ETFs to help investors understand the actual worth of one unit of an ETF. Index funds, on the other hand, don't trade in the market, so they don't face the price-NAV gap issue.
In 2022, nearly 67% of active large-cap funds underperformed the Nifty 100, 55% of active mid-cap funds underperformed the Nifty Midcap 150, and even though just 13% of small-cap funds didn't beat the benchmark, this number was quite high in the preceding two years. If the price is at a premium to the NAV, it's better to wait or buy another ETF tracking the same index.
In conclusion, the growing preference for ETFs in India is due to their intraday tradability, cost-effectiveness, tax advantages, and ease of access, which collectively provide greater control and potential for improved investment outcomes for many investors. However, it's essential to consider the price-NAV gap and liquidity when investing in ETFs to maximise returns.
Personal finance enthusiasts commonly consider mutual funds as a form of investing, and within this category, ETFs have been gaining popularity in India due to their advantages such as higher liquidity, lower expense ratios, better tax efficiency, and accessibility. Yet, when investing in ETFs, it's crucial to evaluate the price-to-NAV gap and liquidity to ensure maximum returns, a factor that doesn't apply to index funds, as they don't trade in the market. Thus, ETFs offer a significant opportunity for improving returns in the realm of personal-finance and passive investing.
