Mutual funds: Know the difference between index funds & ETFs

by Joseph K. Clark

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

difference between

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 deal, and the purchases/sales happen between investors in the regular course of business. In some instances, 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. Your 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 digitalized.

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, considering the closing prices of securities in the portfolio. Another level of price discovery can be built-in in ETFs, though NAV will be published in the evening only. Inequity ETFs, where the underlying stocks are liquid, the implied real-time NAV, at a price prevailing at that point of time, can be disseminated on the website of the AMC. This will facilitate better price discovery for the 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, the corpus size of the fund can change through the defined process.

When a prominent investor intends to dispose of an oversized 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 authorized participants mandated for the fund come into play, or the investor can approach the AMC directly. The AMC will extinguish divisions 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 prices are lower in an ETF, provided you do not trade too often.

Concentration

The rule that one investor can hold a maximum of 25% in an MF scheme does not apply to ETFs. There is no redemption with the AMC in an ETF, and usually, for lot sizes more minor 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 some instances, the purchase or sale can be with the AMC, in a minimum defined lot size known as creation unit.

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