Index funds and ETFs

In simple terms

An index fund aims to match the return of a market index, such as the Nifty 50, by holding the same shares in the same proportions. It does not try to choose better shares or time the market. It simply aims to give investors the index's return, minus small costs.

An exchange-traded fund (ETF) does the same, but its units trade on the stock exchange like shares.

How tracking works

An index is a list of companies with weights, as the Nifty 50 and Sensex lesson explains. An index fund buys those companies in those weights. When the index changes, adding or removing a company or changing weights, the fund adjusts its holdings.

Because the fund simply copies the index, it needs no team of analysts trying to pick winners, which keeps costs low, as the expense ratio lesson explains.

Index funds and ETFs compared

ETF prices and NAV

An ETF's units trade on the exchange, so their price is set by buyers and sellers. Usually it stays close to the NAV, because specialised participants, called market makers and authorised participants, can create or redeem units to profit from any gap. But:

• in thinly traded ETFs, prices can move away from NAV, at a premium or discount;
• the bid-ask spread can be wide, as the liquidity lesson explains;
• in fast markets, gaps can open briefly.

Why funds tracking the same index differ

Several funds may track the same index, but their returns differ slightly, because of:

• expenses, taken from the fund's assets;
• cash holdings, kept for redemptions, which earn less than shares in rising markets;
• trading costs when the index changes or money flows in and out;
• timing of dividends and rebalancing.

The gap between a fund's return and its index's return is its tracking difference; how much that gap varies is its tracking error. Both are covered in the next lesson.

What index funds do not do

An index fund that tracks the market falls with the market. In a bear market, it will fall roughly as much as its index, as the bull and bear markets lesson describes. It provides diversification and low cost, not protection from market risk.

Also, an index fund is only as diversified as its index. A sector index fund is concentrated in one sector.

Why it matters

Index funds and ETFs are among the simplest, cheapest ways for individuals to own a diversified slice of the market. Understanding how they work, the differences between the two, and the pitfalls of thinly traded ETFs helps investors choose and use them well.

Limitations

Index funds deliver the index's return, good or bad, minus costs. Index construction rules, set by index providers, decide what you own. ETF liquidity varies widely. Product rules and costs are set by regulators and fund houses and change over time.

Common mistakes

• Buying a thinly traded ETF at a large premium to NAV.
• Assuming all funds tracking an index give identical returns.
• Forgetting that index funds fall with the market.
• Assuming a sector index fund is broadly diversified.

Try it yourself

1. Find two index funds and one ETF that track the same index.
2. Note their expense ratios and their returns over the same period, compared with the index.
3. For the ETF, check its traded volume and the gap between its market price and its NAV on the exchange website.
4. Decide which you would prefer for a monthly SIP, and why.