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Index fund versus ETF


Both Index mutual fund and Exchange Traded Fund are excellent way for individual stock holders to buy and hold a basket of securities at a low cost, however there are differences that one must consider before deciding on MF or ETF.

1.Flexibility

The first and obvious difference is that ETF is traded like stocks and priced continuously when market is open. MF, on the opposite side, is bought or sold once in a day at the end of day price. Since ETF is traded like stock, all the techniques that apply to stocks can be employed on ETF as well such as limit order, short sales, futures, options etc. If using these trading techniques is your goal, than ETF will be the clear choice. ETF clearly wins in flexibility.

2.Expense ratio

Both Index fund and ETF keep Expense ratio low. However, expense ratio for Index fund is usually slightly higher than comparable ETF. The reason for this difference is that MF issuer sells MF directly to individual investors, so the efforts required from the MF issuer is higher. ETF issuer issues ETF to large institutional investors known as Authorized Participant (AP). In turn, AP sells ETF to individual investors. So, part of the efforts required to sell ETF to individual investors is transferred to AP. That’s why ETF issuer typically charges lower expense to manage ETF. ETF wins in Expense ratio.

3.Brokerage and bid-ask

Since ETF trades like stock, investors will incur transaction costs like brokerage commission and bid-ask spread. If you invest frequently or want to setup Systematic investment plan, brokerage can be a significant cost. Also for low liquidity ETF, bid-ask spread can be very high. Index fund clearly wins in incurring transaction related costs.

4.Flexible Amount

You can invest any amount in MF such as 10000$, but you can only buy ETF in number of units such as 100 units. So if the ETF price is 99$, you can either invest 9999 or invest 10098$, you cannot invest 10000$. At the same time, Index fund might have a minimum investment requirement. If you want to invest a very low amount, you may not be able to buy index fund. Index fund usually wins in investing flexible amount.

5.Tracking error

ETF usually has lower tracking error than Index MF. MF carries higher tracking error due to constant rebalancing required to meet net redemption need every day. Index funds are required to keep cash balance to meet daily net redemption. Additionally to meet redemption requests, index funds have to sell stocks. ETF do not have these disadvantages due to in kind creation/redemption process which does not force Authorized Participants to sell the underlying stocks. Additionally, this process saves money for AP since AP doesn’t have to incur commission and bid-ask spread costs for selling underlying securities. Participation of Authorized participants also ensures arbitrage opportunities do not persist. But if there are not many APs for an ETF, the tracking error can be high for ETF as well. ETF wins in keeping tracking error low.

6.Dividends

Index fund reinvests the dividends immediately whereas ETF accumulates the dividends during the quarter and then distributes it to shareholders. This process works out in favour of index fund as it generates better return for investors and eliminates the need to reinvest dividend. Index fund wins in dividend treatment.

7.Liquidity

In case of Index fund, you are guaranteed to receive money at end of day NAV, when you sell. There is no guarantee in case of ETF. If ETF has low liquidity and high bid-ask spread, you will receive much less amount than NAV of ETF. Index fund wins in liquidity.

So, you should consider multiple factors before you finally decide on ETF or MF. While many people these days blindly follow ETF, an intelligent investor will always consider both the options before deciding what is right for her based on all the factors.

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