What are Index Funds? ETFs Vs Index Funds | Should you invest in them?

Mutual funds are one of the best investment avenues for your money to flourish. They offer you a plethora of schemes to choose from. Depending on your risk appetite, investment objectives and time-frame, you can select right mutual fund schemes and align them with your financial goals.

Mutual Funds are primarily classified as Equity and Debt Funds. Equity funds are further classified into Diversified funds, large cap funds, mid & small cap funds, Sector Funds, Tax saving funds, Index Funds and the list goes on..Similarly, in case of debt schemes there are monthly income plans (MIPs), gilt funds, fixed maturity plans (FMPs), Liquid Funds and many more.

Some mutual fund schemes are actively managed by Fund managers, whereas some are passively managed. Index Funds fall under the category of Passive Funds. So, what are these Passive Funds?

What are Passive Funds? What are Index Funds?

An actively managed mutual fund is a fund wherein a fund manager or a management team makes decisions about how to invest the fund’s money. Here, the fund manager aims to outperform the market by frequently buying and selling securities that they think are going to do better than others.

A passively managed fund, in contrast, simply follows a market Index. In this case, the fund manager merely buys a portfolio of assets that mimic an Index. Passive Fund aims at generating returns that are almost the same as the index it is tracking. Passive funds also aim to keep the tracking error as low as possible. (What is tracking error? – Tracking error is the difference between a portfolio’s returns and the benchmark or index it was meant to mimic or beat.)

Index Funds are known as Passive Funds. For example : UTI Nifty Index Fund is a passive equity oriented fund. The investment objective of this fund is ‘to generate returns that are commensurate with the performance of the Nifty index’. The CNX Nifty Index has 50 stocks and this fund also invests in all of these 50 stocks. The scheme would alter the scrips/weights as and when the same are altered in the S&P CNX Nifty Index.

Below are the top ten holdings of Nifty index and same is the case with UTI Nifty index fund.UTI Nifty Index Fund Portfolio top holdings Stocks pics

Index Funds Vs ETFs

Both Index Funds and ETFs (Exchange Traded Funds) track the performance of an Index like Sensex or Nifty or any other index. So, the underlying portfolio of an Index fund and ETF is same but their structure can be totally different.

  • Index Funds are open-ended funds, while ETFs are like close-ended funds.
  • The units of ETFs are listed on Stock exchanges. The units of Index funds are not listed on the exchanges.
  • You can buy ETF units only from an exchange. The ETF prices are ‘Live’ / ‘Real-time’ on the stock exchange and can be traded like individual stocks. The NAV of index funds are determined at the end of the trading day.
  • ETFs being similar to equity shares, you will need demat and trading accounts to buy them. But Index funds can be bought or sold directly from the fund house (and through other modes), similar to other mutual fund schemes.
  • ETFs generally have a lower expense ratio and lower tracking error than Index funds.
  • The portfolio details of an ETF fund are disclosed on a daily basis whereas an Index Fund’s portfolio holdings are disclosed on a periodic basis.
  • The ETF assets (fund’s corpus) are fully invested at all times. Whereas, Index funds are allowed to hold some portion of their assets as cash, either to meet redemption requests from investors (or) to cushion against volatility when the markets are too volatile.

Top Performing Index Funds & ETFs

Below are some of the top performing Index Funds (large-cap oriented) and ETFs.

Best Index Funds Top Index mutual funds highly ranked five star rated index funds Nifty index

UTI Nifty Index fund, IDFC Nifty Fund & HDFC Index Fund – Nifty plan, are some of the large cap oriented index funds. Above table has a comparison between the returns generated by these funds and Nifty index. You can observe that the expense ratio is very low.

You can also observe that the returns generated by an actively managed Large-cap fund like SBI Bluechip are far superior than Index Fund’s. It is an actively managed fund, hence the expense ratio is on the higher side.

Below are some of the large cap Index funds which have BSE Sensex as their Index; (BSE Sensex, a collection of 30 most liquid and traded stocks on the Bombay stock exchange)index funds bse sensex

Below are some of the ETFs with NSE Nifty as a underlying index;

best ETF funds best exchange traded funds large cap nifty bse

There are various Index funds and ETFs representing mid-cap or sector-based indices too. For example : ICICI Pru Nifty Junior Index Fund (CNX Nifty Junior is the index). Gold ETFs are also available.

How are Capital gains on Index Funds or ETFs taxed?

Equity Index Funds & Equity ETFs are treated as regular Equity oriented funds for taxation purposes.

  • The STCG (Short Term Capital Gains) tax rate on equity Index funds is 15%.
  • The LTCG (Long Term Capital Gains) tax rate on equity Index funds is NIL. From FY 2018-19 onwards, the LTCG (Long Term Capital Gains) tax rate on equity funds is 10% on LTCG exceeding Rs 1 Lakh.

Gold ETFs are considered as Debt oriented funds for taxation purposes.

  • The STCG tax rate on Gold ETFs is as per the investor’s income tax slab rate.
  • The LTCG tax rate on Gold ETFs is 20% (with Indexation benefit)

(Read : ‘Mutual Fund Taxation rules – Capital Gains Tax Rates on MFs‘)

Should you invest in Passive Funds?

  • Core Portfolio : Should one consider Index Funds or ETFs part of ones core Mutual Fund Portfolio? – I don’t think so. You may consider regular Equity oriented funds which are actively managed by fund managers as part of your core portfolio.
  • Index is the key : How good is your Index fund or ETF is totally dependent on how well-diversified the underlying Index is… I believe that indices like Nifty or Sensex are not that well diversified ones. So, if you really want to make an index fund part of your overall MF portfolio, you can consider an index fund which is more broad-based, for example; CNX 500.
  • While choosing an ETF, liquidity factor should be given high priority. It is preferable to buy the most liquid ones. If you get stuck with illiquid ETFs, not only will your returns suffer but selling them may not be an easy proposition. Likewise, when you are looking to invest in an Index fund, go for the ones with lower expense ratio, because high expense ratio can eat into your long-term returns.
  • If your investment objective is to get superior returns than a benchmark index, you may have to consider regular equity oriented funds. Most of the regular equity oriented funds have better track record than index funds / ETFs. For example : In the above Table-1, you can notice that SBI Bluechip fund has beaten index funds hands down.

Personally, I do not have any holdings in either ETFs or Index funds. Do you invest in Index Funds / ETFs? Do you believe that they should be part of one’s core MF portfolio? Kindly share your views!

(Image courtesy of Stuart Miles at FreeDigitalPhotos.net) (Reference for Returns info ; valueresearchonline) (Post published on 09-December-2016)

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  • Soumitra says:

    Is it advisable to invest in the foreign market through ETF like Motilal Oswal NASDAQ100 ?

  • pankaj h parmar says:

    Dear Shrikanth,

    If I want to invest for a period of 20-30 years (to build a fund for my child), is it advisable to invest in index fund ?, as most of the economic thinkers (like warren buffett) have said that no fund manager or investor can outperform the market in the long run i.e. 20-30 years.

    • Sreekanth Reddy says:

      Dear Pankaj,
      For a retail investor who does not have time or interest to market on a monthly basis then advisable to invest regularly in index fund(s).
      Kindly note that property Asset allocation and regular re-balancing of portfolio should be given importance..

      • pankaj h parmar says:

        Thanks for your reply. One more query. Is index fund the best choice to build a fund for child (through SIP) i.e. for a very long time 25-30 years ? If no, is there any better alternative ?

  • saurabh says:

    Hi Sree, i have a query with regards to recent NFO from mirae asset group – Mirae asset next 50 etf. As per the description mentioned on there website, this will be open ended fund. This is contrary to your article. Please advise if this is same is normal etf and if trading account is needed to purchase it. These will be listed?
    please provide your feedback.

  • t s ghosh says:

    hi sreekanth,

    Thanks for sharing your valuable knowledge on ETF.

    Need some suggestion from you on ETF’s as direct versus regular mode of purchase. Which one is better for retail investors.

    what I noticed is the majority of the sites like money control or value research do not have data for direct mode ETF’s!


    t s ghosh

  • Amlan says:

    Hi Sreekanth,

    First all of thank you so much for your valuable comments and suggestion.

    Just a quick question do you feel investing in a index fund would be better than investing in a large cap fund in current situation (after recent change in SEBI rule).

    I never invested in Index fund till now… but currently I feel it would very difficult for active large cap fund manager to generate the alpha . Could you please suggest if I can invest in some index fund replacing large cap( I am investing in SBI blue chip fund in my portfolio and it is for long term investment).

    Thanks in advance.

    • Sreekanth Reddy says:

      Dear Amlan,
      Yes, one can seriously look at Index based funds after SEBI’s reclassification of funds.

  • Samir Kangutkar says:

    Hi Shree,

    Can you share a list of best performing ETF’s for a individual with long term horizon.

  • Prakash says:

    Dear Sreekanth,

    Greetings of the day !

    Would you please share how to find out liquidity factor of ETF so as to find our which ETF is the most easy to liquidate.


    Prakash Dsa

  • Rahul says:

    Hi Srikanth,

    I am planning to do lumpsum investment for both myself and spouse.

    For me horizon would be short term(6-9 Months) and for spouse it would be medium term(1-2Years).

    My objective is to get better return than conventional savings account and at the same time liquidity of the data if required for any emergency.

    Kindly suggest some good liquid fund/ultra short term/medium term funds.

  • Tarun says:

    What’s your view on CPSE ETF which is to be relaunched on 17th Jan?

  • Dr. Jawahar Lal bansal says:

    Dear Srikant,Very good article. Kindly compare Index funds with PE funds.
    Waiting for your update on best mutual funds for 2017.

  • Devadoss Eswar says:

    Very lucid description and simple style ! It is the reflection of your mature knowledge of the topic, Sreekanth ! I deeply appreciate this contribution aimed at and for the benefit of small investors !!

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