Index funds or ETFs: which one to choose?

Many of you have been asking us questions on investing in index funds or ETFs. The questions are broadly on these aspects:

• Can I have portfolio with only index funds/ETFs?
• How to add index funds to my existing portfolio?
• What index funds or ETFs are available?
• Give me a list of index funds with lowest tracking error
• Are ETFs better than index funds as they have lower cost?

I’ve tried to provide answers to some of these questions here. Of course for the recommended list of ETFs or index funds, you will have to go to Prime ETFs or the passive funds under Prime Funds. You can also look at our MF Review tool to know whether the index funds of your choice are buys or sells (we have no holds in this category).

In this article, I have given links wherever key terms such as ‘tracking error’ or ‘bid-ask spread’ need to be explained. As there is already enough material on these, I will not be repeating it. Also, to know the basics about ETFs or index funds, you will find plenty of material online.

Part 1 – Index funds or ETFs? How to compare

Let’s tackle the question of costs at the outset. In our view, this decision is more a matter of convenience than merely a matter of costs. The reason why the answer is not a straight one is ETFs and index funds cannot be directly compared for multiple reasons. Let me explain why.

Total cost of owning an ETF

First, you would have noticed that the expense ratio of ETFs is far lower than that of index funds. However, take passive funds based on Nifty 50 as an example. The expense ratio of index funds (direct plan) come to an average of 0.2% while it is 0.08% for ETFs (as of May 2020). Most investors immediately conclude that ETFs are cheaper.

Prima facie, they are – but you need to look at the total cost of ownership (TCO) before arriving at a conclusion. Calculating the TCO is complex and not feasible unless a dedicated team (that works for institutional investors) does it. For example, the bid-ask spread may be tightly managed in an ETF that has high liquidity. It may not be in other illiquid ETFs. So, the costs can vary significantly.  

And above all this you need to really wonder whether a 12 basis-point difference in TER (total expense ratio of ETF and index funds and before the above-mentioned costs for ETF) between an index fund and an ETF can make a significant difference to your returns.

Tracking error

In its true sense, tracking error is the standard deviation of your ETF portfolio returns over the index returns. And ideally, your ETF portfolio returns should be net of the costs. Remember, in an index fund, all the cost is captured in your total expense ratio. Hence, the tracking error of an index fund over the index is a reliable number. In the case of ETFs, there are multiple layers of complexities.  

• What you see as returns for ETF in many places is based on the ETF NAV and not the market price
• Tracking error in most databases provide the deviation between the ETF NAV returns and the index and not the ETF market price returns and the index.
• ETFs can declare dividend, either added as units or as cash. Hence, their NAV and market price will fall to that extent. So, how you compare them with index matters (TRI or just the index).
• Also, comparing ETF returns (based on market price or NAV) directly with index fund returns may not also be correct due to the dividend component in ETF and the indirect costs you miss out in ETFs.

Let us give you a simple example with the Nifty 50 index funds and ETFs. The data below shows the tracking error for rolling 1-year returns (rolled daily to give 3-year data) of index funds and ETFs. To give leeway to ETFs (where dividend distribution happens in some cases) we took the Nifty 50 and not the Nifty 50 TRI. We took a stiffer benchmark for index funds with the Nifty 50 TRI.

On an average, the Nifty index funds fare well on tracking error.

But tracking error is not so simple with ETFs in India.

• One, the high market price tracking error, it appears, is more on the upside. That is, the ETFs are delivering more than the index, especially in recent times. In months such as March 2020, ETFs fell far lower than the index simply because their demand held up their prices way above the index. Remember, ETFs such as the Nifty 50 and Nifty Bank are  used by derivative traders. While this is not necessarily a bad thing, it may not help you to buy an ETF whose price is supported primarily by high demand (which can fall later).
• Two, on price deviations from NAV, the graph below will show you that it is evenly divided – i.e, Nifty ETF market price returns was more than NAV returns only half the time (using 1 year return rolled for 3 years). If you notice, market price returns are higher than NAV returns in recent times. This shows that there is higher demand for the ETFs. If you bought a Nifty ETF today, chances are that you will be buying it at a higher price than the NAV.

Liquidity and trading days

One of the biggest challenges in ETFs is in identifying ETFs with healthy turnover and which are traded steadily on all days. There are ETFs that may have healthy volumes on some days and no trading on other days. For example, the Nippon India ETF Sensex is traded just 67% of the days in the last 90 days, whereas the Nifty ETF from the same house does not have any such problem.

Not just that. The volume per se in some of the exotic ETFs are so poor that you cannot possibly be risking investments in them. For example, the NV-20, a value-based ETF suffers from poor turnover although the index is a high-performing one compared with other large-cap indices. While the highly liquid ETFs can have turnover of over Rs 30 crore a day, some of the ones we mentioned above have turnover as low as Rs 50,000 and untraded on many days!

So, liquidity and consistency in trading become 2 important factors when looking at ETFs.

Part 2 – Using Index funds or ETFs in portfolios

Now that you know the complexities in ETFs’ tracking errors and costs, why go for ETFs at all?

Why ETFs are looking interesting

To us, there are two reasons why ETFs have begun to look interesting compared with index funds: One, plenty of PF money and institutional money has created liquidity in some ETFs.

Two, with more factor-based indices coming up, there are more options in the ETF space than in index funds. There are 77 ETFs compared with just 36 index funds. And ETFs span market cap, thematic and strategy indices.

With this, let’s look at how to use ETFs and index funds as part of your portfolio.

Building a passive-only portfolio

• If you are an investor who does not want to actively choose funds, worry about fund manager performance, review the funds or seek proper advice to maintain quality funds, then index funds or ETFs is the way forward.
• If you want even less hassle, index fund is the better option, unless you have a trading account, know about ETFs and are aware of all that we mentioned above.
• Do not choose index funds based on individual parameters. Some of you asked us for the lowest cost index fund. Remember, some indices by their very nature have slightly higher cost (of maintaining) than others. For example, a Nifty Next 50 index fund will have a slightly higher expense ratio than the Nifty 50 index fund. The question is about the suitability of a Nifty or Nifty Next 50 in your portfolio and not about the lowest cost across indices.
• If you are still keen on ETFs, simply go with Nifty based ETFs with high volumes that we have provided in our Prime ETF list.
• Avoid picking individual parameters alone to choose ETFs. A fund with low tracking error may suffer from poor volumes and vice versa. When we pick them, various metrics are weighted and then ranked.
• We have both index funds in our Prime Funds list and ETFs in Prime ETFs. We have passive fund strategies, mixing indices to provide you a category-allocated portfolio. We build these by first putting a filter on the quality of indices – choosing those that have a higher potential of challenging active funds – and then looking at the fund parameters such as liquidity, tracking error, expense ratio and so on.
• For debt, we would prefer that you continue to use active funds unless the ETFs have healthy volumes (like Bharat Bond ETF). We have written earlier that active funds offer sufficient options in the debt space.

Using passive funds in an active portfolio

If you are an active investor who is capable of handling an active fund portfolio, you can still complement them with passive funds; thereby reducing portfolio cost as well.

• Where active funds are struggling to beat their indices or the index funds have unique propositions (example smart beta index or global index), then it makes sense to look at them to complement your portfolio with passive investing.
• For example, with increasing evidence that large-cap funds are struggling to beat large-cap indices, there is a case for substituting them. Similarly, select smart-beta indices are showing signs of beating their parent indices. Our job is to help identify such options for you.

Some of you ask us why we have active funds at all, when index funds are beating them. The active options that we have are the ones that have been able to beat their benchmarks consistently (including the couple of large-cap funds we have).  Any underperformance would be short term and we keep tabs on them. In other words, we don’t provide active options unless the active management delivers superior returns.

As we are under no compulsion to ‘sell’ funds to you, our objective is to ensure you get optimal returns at lower cost.

See also : Our rating of the best Index Funds in India