Index Funds vs ETFs: Main Differences for Indian Investors

Index funds and exchange-traded funds (ETFs) are popular passive investment vehicles that aim to replicate the performance of a stock market index, such as the Nifty 50 or Sensex. While both provide exposure to a diversified portfolio at relatively low costs, they differ significantly in terms of how they are bought, sold, managed, and priced. For Indian investors, especially those new to the stock market or passive investing, understanding these differences can help in making informed choices aligned with personal goals and risk appetite.

This article explores how index funds and ETFs work, their features, limitations, tax treatment, and how investors typically use them in portfolios.

Index funds are mutual fund schemes that aim to replicate the performance of a specific index by investing in the same stocks and in the same proportions as the underlying index. They are managed passively, meaning the fund manager doesn’t actively select stocks but follows the index composition.

Investors can purchase index funds directly from the asset management company (AMC) or through mutual fund platforms. The price of an index fund is based on its net asset value (NAV), which is calculated at the end of each trading day.

Key Features of Index Funds:

• Traded only once per day at NAV
  

• Minimum investment can start from ₹500 (via SIP)
  

• Managed passively, mirroring the index
  

• Typically used by investors with a long-term, hands-off approach
  

ETFs are investment products that also replicate market indices but are traded on stock exchanges just like individual stocks. An investor can buy and sell ETFs throughout the trading day at market-determined prices, which may fluctuate due to demand and supply.

To invest in ETFs, an investor needs a demat account and a trading account with a stockbroker. ETFs typically have lower expense ratios compared to index funds, but may incur brokerage and transaction costs.

Key Features of ETFs:

• Traded in real-time on stock exchanges
  

• Prices change during market hours based on market demand
  

• Require demat and trading account
  

• Offer flexibility and are suitable for active traders or those familiar with the stock market
  

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: Ideal 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
  

The taxation on index funds and ETFs in India follows the same rules as equity-oriented mutual funds:

For Equity Holdings:

• Short-Term Capital Gains (STCG): Taxed at 15% if held for less than 12 months
  

• Long-Term Capital Gains (LTCG): Taxed at 10% if gains exceed ₹1 Lakh in a financial year
  

Dividends:

• Taxed as per the investor’s income tax slab since the abolishment of the Dividend Distribution Tax (DDT)
  

Investors should keep track of holding periods and plan redemptions or transactions accordingly to minimise tax liability.

Choosing between index funds and ETFs depends on your investment behaviour, infrastructure (demat/trading account), and comfort with market execution:

• Index funds are commonly used by:
  

  • New investors
    

  • Individuals without a demat account
    

  • Those opting for SIPs and long-term approaches
    

  • Investors not tracking daily prices
    

• ETFs are often used by:
  

  • Investors with demat accounts
    

  • Those familiar with trading platforms
    

  • Individuals seeking real-time trading flexibility
    

  • Investors managing larger amounts with focus on lower costs
    

Both are suitable for passive investing, and in fact, can complement each other in a diversified portfolio.

Investors should avoid these mistakes 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
  

A clear understanding of purpose, costs, and execution will help avoid regretful decisions.

Both index funds and ETFs offer an affordable and efficient way to gain broad market exposure. While index funds offer simplicity and ease of access, ETFs bring in cost savings and flexibility for those comfortable with stock trading platforms. Ultimately, the choice depends on your investing style, comfort with financial tools, and the effort you’re willing to put into managing your portfolio.

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.