Over the last few years, mutual funds have been quite a favoured kind of investment tool. But, currently the limelight is on index fund and exchange traded funds (ETFs) for a good many reasons.
An index fund belongs to the family of mutual funds and comes with a special portfolio made to compare or monitor various parameters of the current market index. An example for this could be the Standard & Poor (S&P) CNX Index. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. It is evident that managed capitals provide better divergence than many accrue via direct investment of shares. There are hundreds of such funds out there that can be classified into two groups in effect, namely, active and passive funds. Actively managed funds try to beat the standard index using shrewd share selection. But passive funds merely see if it can reach the yardstick. Now you can guess passive funds is just another name for index funds and this is how it got the name. Index funds will comprise of all securities in any particular index, exactly in the ratio given in the index. For instance if share X shows 5 percent, then the index fund will also have the same percentage.
Quite a few shareholders are hesitant to invest in index funds as the proceeds are nothing fabulous. But there are some not-so-well-known perks to investing in index funds given below.
- Tax Respite: Shares tend to remain in one index for quite a long period. This means index funds will also keep their stocks for as much time. If you purchase a share but do not trade it, you will be eligible for some tax break as it will not be considered as a ‘capital gains tax liability’. When it comes to actively managed funds, tax aspect is often overlooked.
- Reasonable costs: An index fund does not require much research expenses, or the huge remunerations and extras that are shelled out to some fund brokers/ managers. One reason why many index funds are around 0.50 percent economical than active mutual funds.
- Diversification: As index funds deposit in each one of their shares in a single index, they offer a better level of diversification than actively managed funds. This improved diversification gives the investor a chance to bring down risk, particularly those haphazard ones. This is one of the few times where you can reduce risk without sacrificing the return.
Exchange Traded Funds (ETFs):
ETF basically a type of mutual funds designed to monitor how an index is performing. It also keeps a track on specific commodities or financial services. One example for ETF is INDA. ETFs capitalize in a selection of stocks, thus offering you, as the depositor, access to a prolific choice of markets, segments as well as asset types. As they are recorded on stock exchanges, ETFs are dependent on brokerage as are every other shares on it.
ETFs can be in the form of bonds, commodities, currencies or equities. It has a lot of benefits, which are:
- Feasibility: ETFs shall be purchased and vended the same way you do other shares; be it online or through a broker.
- Transparency: They are traded freely and visibly. And as they are entered on exchanges, their values are known to everyone on the day.
- Risk Divergence: ETFs has scope for some amount of diversification, which gives you a peek into other markets too.
- Nominal Expenses: Overall expenditures for ETFs (0.3 to 1 percent) are normally lesser than for other shares (which mostly ranges from 1.5 to 3 percent).
Differences between index funds and exchange-traded funds (ETFs)
There are a few significant differences between index funds and exchange-traded funds. Let us take a look at the comparison between index funds and ETFs:
- If you decide to purchase an index fund, it will get added in the assets under management (AUM) of that particular fund. Meanwhile, when you purchase an ETF, it does not add to the AUM. You can purchase or sell this fund only if a counterparty is involved in the transaction. In such circumstances, market liquidity is essential for any ETF that you choose.
- The expense ratio of an index fund is much higher than that of an ETF. However, since index funds are purchased and sold only on the exchange like other stocks, an investor will need to keep other fees and charges in mind such as statutory charges, Securities Transaction Tax (STT), and brokerage in mind. You will be incurring these charges also.
- Index funds require a higher cash balance for taking care of redemptions. Apart from the market risk known as Beta, there is another risk known as the tracking error risk. This risk is more prevalent in index funds when compared to ETFs.
- Index funds are mutual funds. Hence, they can be bought and sold only at the end of the day (EOD) NAV and they can be bought only during trading hours. Meanwhile, ETFs can be bought and sold at a price that is somewhat based on the Nifty fraction.
- When you receive dividends for ETFs, you will get them credited to your registered bank account. On the other hand, for index funds, you can choose a dividend reinvestment plan or a growth plan. Here, your dividends will directly get substituted by units.
When you compare the various features of index funds and ETFs before making a choice, you should ideally assess the liquidity and costs of both these funds to select the most appropriate one.
GST rate of 18% applicable for all financial services effective July 1, 2017.