Index Funds vs ETFs: Main Differences for Indian Investors

Understanding the differences between index funds vs ETFs is important for investors evaluating passive investment options in India. Both investment products aim to track market indices at relatively low costs, but they operate differently in terms of pricing, execution, and the way investors participate in them.

For individuals who are new to passive investing or looking to choose between traditional mutual fund structures and exchange-traded formats, knowing how these two options differ can help in aligning investments with risk preferences, time horizon, and convenience.

This article outlines the key distinctions between index funds and ETFs, explains how each product functions, and highlights their features, costs, taxation, and common use cases for Indian investors.

When comparing index funds vs ETFs, index funds serve as a straightforward and accessible option for investors who prefer a passive approach to equity markets. They provide market-linked returns without the need for active stock selection or continuous monitoring.

1. Definition of Index Funds

Index funds are mutual fund schemes that seek to replicate the performance of a specific benchmark index, such as the Nifty 50 or Sensex. These funds follow a passive management style, holding the same securities and in the same weightage as the underlying index.

2. How Index Funds Work

Index funds maintain a portfolio that mirrors the composition of their chosen index.

The fund’s value is determined by its Net Asset Value (NAV), which is calculated at the end of each trading day. Purchases and redemptions are processed at this closing NAV, ensuring uniform pricing for all investors on a given day.

3. How to Invest in Index Funds

Investors can access index funds through:

• The Asset Management Company (AMC) directly

• Registered mutual fund platforms

Many index funds allow small-ticket investments, with systematic investment plans (SIPs) often starting from ₹500.

4. Key Features of Index Funds

• Transactions occur once daily at the closing NAV

• No demat account is required

• Suitable for long-term, passive investors

• Designed to closely track the chosen index with minimal intervention

Exchange-traded funds (ETFs) combine diversified market exposure with the convenience of real-time trading. For investors who prefer market-linked execution and flexibility, ETFs serve as an accessible way to track indices while trading them like individual stocks.

1. Definition of ETFs

ETFs are market-linked investment products designed to mirror the performance of a specific index. They hold the same securities as the underlying index and follow a passive, rules-based approach. Unlike traditional mutual funds, ETFs are listed on stock exchanges and can be traded throughout the trading day.

2. How ETFs Work

ETFs replicate an index by holding its constituent securities in similar proportions. Their prices are determined by market forces during trading hours and may differ slightly from the fund’s indicative value due to demand and supply. Since ETFs trade on exchanges, they provide intraday liquidity and continuous price discovery.

3. How to Invest in ETFs

Investing in ETFs requires:

• A demat account to hold ETF units

• A trading account with a stockbroker to execute buy or sell orders

Investors purchase ETFs at market prices, and transactions may involve brokerage fees, securities transaction tax (STT), and other applicable charges.

4. Key Features of ETFs

• Traded on stock exchanges during market hours

• Prices fluctuate in real time based on investor activity

• Require a demat and trading account

• Suitable for investors who prefer direct market execution or intraday flexibility

Index funds may be suitable for those who want a passive, low-maintenance approach to equity investing. Here are some reasons why they are widely used:

• No demat account required: Accessible through mutual fund platforms or AMCs directly

• SIP options available: Suitable for disciplined long-term investing

• Simple to understand: Doesn’t require monitoring of prices during the day

• Less volatile: NAV changes only once daily, reducing intraday price anxiety

ETFs may be preferred by those who prefer flexibility and want to take advantage of intraday price movements:

• Real-time trading: Can buy/sell any time during market hours

• Lower expense ratio: Cost-effective for large investments

• No exit load: Unlike some index funds, ETFs typically don’t charge exit fees

• Higher transparency: Live prices and portfolio details are available instantly

Since 23 July 2024, all mutual fund categories, equity, hybrid, or debt, follow the same capital gains tax structure, based on the holding period only, not asset allocation.

Here is the updated taxation rule applicable to both index funds and ETFs:

Capital Gains Tax (Applicable to Both Index Funds & ETFs):

• Short-Term Capital Gains (STCG): Taxed at the investor’s slab rate when units are held for less than 36 months.

• Long-Term Capital Gains (LTCG): Taxed at a flat 12.5% (without indexation) when units are held for 36 months or more.

Dividends:

• Dividends from both products are taxed as per the investor’s income tax slab, as per the post-2020 rule (no DDT).

Selecting between index funds and ETFs depends on factors such as investment behaviour, availability of a demat account, and comfort with market execution. Both options provide market-linked exposure, but each caters to a different type of investor profile.

Who Typically Uses Index Funds

Index funds are generally preferred by investors who prioritise simplicity and long-term investing without frequent market involvement. They are suitable for:

• Individuals new to equity investing

• Investors who do not maintain a demat account

• Those opting for systematic investment plans (SIPs)

• Investors who prefer not to monitor market movements during the day

Who Typically Uses ETFs

ETFs are commonly used by investors who prefer market-linked execution and the ability to buy or sell units during trading hours:

• Investors with an active demat and trading account

• Individuals familiar with exchange-based transactions

• Those seeking the ability to buy or sell units at real-time prices

• Investors deploying larger amounts with an emphasis on lower ongoing costs

Both instruments can be included in a passive investment strategy and may complement each other within a diversified portfolio.

Common issues investors may encounter while investing in index funds or ETFs:

• Ignoring tracking error: Always compare how closely the fund tracks the index

• Assuming liquidity in ETFs: Not all ETFs have high trading volumes

• Not factoring in brokerage charges in ETFs: These can erode returns on small investments.

• Mixing goals: Define whether you are investing for growth, income, or specific goals

Understanding these aspects can provide clarity during evaluation.

Both index funds and ETFs provide structured ways to access market-wide portfolios at relatively low costs. Index funds offer a straightforward, passive investment format, while ETFs function through the stock exchange and operate with intraday pricing. The two options differ mainly in how they are bought, priced, and managed, and understanding these distinctions can help clarify how each product functions within the broader investment landscape.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.