“If you are a long-term investor, then you have a choice between Nifty ETF and the Nifty index. I am just taking one example, this can be multiplied across similar index funds with similar ETFs. My submission is that for long-term investors who are basically buy-and-hold investors, the index option makes far more sense than the ETF option,” says Harsh Roongta, Founder, Fee Only Investment Advisers LLP.
Let us talk about the difference in these two ways of investing in passive instruments, index fund or an ETF. Let us start with an ETF. What exactly is an ETF and why is it a low-cost option of investment?
ETF by definition is a passive fund in the sense that its composition is a pre-decided. Typically, it will track an index, though not always. So, the best-known ETF, let us say, is the Nifty BeEs, which tracks the Nifty 50 index. But there will be several such ETFs that are available.
It need not only be in equity. Now, we have debt ETFs, which, you know, track debt index. There are also gold ETFs. So, ETFs are a way of investing. The basic thing is that the ETF will consist of pre-decided securities in a pre-decided proportion and it is listed on the stock exchange, which means one can buy or sell it like any other security. It continues to be a mutual fund, but it is listed on the stock exchange, and therefore, one can buy and sell it on the stock exchange.
For example, if you want to do trading in the Nifty, one way is that. If you want to do trading in cash, in the immediate market in the Nifty, then you would buy a Nifty ETF, so that you get the exposure in the market. You buy that Nifty ETF. There are several Nifty 50 ETFs available. There is a Nifty 50 BeEs among the ETFs and that is the most famous.
And is an index fund different from an ETF? If we have to just specify this through a few criteria or parameters, what would those parameters be?
Suppose you take a Nifty50 ETF and a Nifty50 index fund, the only difference is that the Nifty50 ETF is listed on the stock exchange and therefore it is pre-created. A Nifty 50 index is not listed on the stock exchange and the AMC is making it otherwise, it is absolutely the same. It has many implications, especially for long-term investors.
If you want to trade, then index is not the right product for you. If you want to trade on the Nifty, then you have no choice but to go for the Nifty ETF. If you are a long-term investor, then you have a choice between Nifty ETF and the Nifty index. I am just taking one example, this can be multiplied across similar index funds with similar ETFs.
My submission is that for long-term investors who are basically buy-and-hold investors, the index option makes far more sense than the ETF option.
What about the performance? If I have to consider a performance of a similar kind of a fund category in an index and an ETF, do we see any difference in terms of returns and performance, or is it the same?
In the case of an index fund or an ETF tracking the same index, basically it will be replicating the index. You do not really want it to have too much higher or too much lower than that. The way to look at it is to look at the tracking error. There are other issues which we will highlight later. But if you even look at the tracking error, you will find a very interesting thing. The ETFs typically tend to have a lower expense ratio.
Therefore, if you do a tracking error, again I am taking the example of the most traded ETF, which is Nifty 50 BeEs. If you take that example, then the tracking error, which means the amount or the percentage by which the return from that ETF varies from the NAV, that is the lowest for Nifty 50 BeEs ETF. It is at 0.08%. This data is daily tracking error over the last four years. It has been updated till June 2022, but it has remained pretty steady at 0.08%, which means if the index returns 10%, this is likely to return 9.92%.
Now, the point is that this is apparent. If you will look at any index fund tracking, the best is say, UTI Nifty Index Fund. It has a tracking error of 0.14%. So, on the surface, it would seem that if you just looked at performance, you should always go for the ETF rather than the index because the ETF has a lower cost.
But if you dig a little deeper, do not go by the tracking error based on the NAV. You look at the tracking error based on the closing market value. There you will find that the tracking error jumps to 4% plus, which means based on NAV, yes, the tracking error is low, but what is the experience of the investor? That is the price at which you will buy or sell in the market. The tracking error is several multiples of what an index fund gives. Add to that, there will be brokerage costs. Therefore, just for the tracking error reason also, ETFs do not make sense for an individual investor.
Do you think an index fund is much more diversified than an ETF?
It cannot be more diversified because it is tracking the same index and so the shares and proportions are the same. The ETF is more expensive because the price is not reflecting the underlying values of the shares. There is a bid-ask spread. The price at which you buy and the price at which you sell the difference is very high. There is a lack of liquidity. There is no surety of transaction unlike an index fund where you can say that okay I want to buy Rs 10,000 worth, you cannot do that with a ETF.
You have to specify how many units you want to buy, at what price in an ETF versus an index fund. You cannot do SIPs in an ETF and that is one of the biggest drawbacks of the ETF. Liquidity is a serious concern and even if it is available, the price when you want to sell it drops. So, you take out the top one or two ETFs and liquidity will be a problem for a retail investor. Everything that I am saying applies to individual investors who buy and hold. If you want to trade, you have no option but the ETF.
What should be the proportion and what should be the kind of exposure if at all you want to go passive at this current moment in any aspect in your portfolio?
Both the ETF and the index fund are passive. If they are following the same index, there is no real difference except for these are operational differences but they mean a lot. As to what percentage should be passive, that really depends on the client because the biggest thing about following investment is to look at the objectives and goals, resources, timeframes and risk profile. Based on that decide an asset allocation.
Within that asset allocation, maybe passive is best, you can do passive in everything now. You can do passive in equities, debt, gold and you can also do a mix of passives that does self-balancing. Pretty powerful options are now available in passive and more are becoming available every day now.
Obviously, certain percentage of your volatile asset that you might have allocated to say equity, you might want to take an active exposure because where you are targeting better than index returns, you would have to take more than index risk and to that much extent you should go active and that really is asset allocation decision rather than there being a thumb rule for this.
Is there a regular and direct scheme also in index and ETF?
ETF by definition is direct, there is only one scheme, it is listed that is the only security that is available and no commission gets paid to anybody in the ETF. In any index fund that follows the normal SEBI rule, there cannot be a mutual fund scheme that does not have direct and regular both options that are available, it is not possible. All schemes will have both.
What would be the cost structure of an index fund or an ETF?
If I take the example of Nifty 50 BeES, the cost structure is about 0.05% the ETF. If you take say the UTI Nifty index, the cost is around 0.09% or something, yet if you do the error based tracking in the case of the index obviously on the NAV because that is what the client gets. But in the case of an ETF, if you do it based on market price, the tracking error is far, far, far higher in the ETF than it is in the index fund.
If we have to talk about a risk averse investor buying these kinds of products, there is no relation with risk going away completely with this kind of route of investment?
It depends. There is a liquid ETF and there is a liquid fund as well. Of course, both are low risk. If it is following the same index, then from a risk perspective, there is nothing to choose between index and an ETF. I think all the points that I mentioned are based on cost perspective and therefore return perspective and operations. Those are the important things that are different between the index fund and an ETF following the same index.
