Last Updated on Jan 3, 2025 by Harshit Singh
Investing need not be an action movie — fast-paced, dramatic, and full of suspense. Sometimes, the best strategy is a calm and steady approach. That’s where passive investing comes into play, starring two fan-favourite actors: Exchange-Traded Funds (ETFs) and Index funds.
In this article, we’ll explore the nuances of passive investing – dissecting the differences between ETFs and index funds.
Table of Contents
What is Passive Investing?
At its core, passive investing involves tracking the performance of a market index, such as Nifty 50 or Sensex, rather than trying to outperform it. When you invest money into an index fund, that money is used to invest in all the companies that make up the particular index, giving you a more diverse portfolio than buying singular stocks.
In contrast to active funds, passive funds do not require the fund manager’s expertise to pick out individual stocks.
An actively managed fund means a fund manager is more involved in decision-making and is more actively buying, selling, and managing investments to outperform the market. In passively managed funds, the fund manager aims to replicate the market index’s performance by mirroring its composition rather than attempting to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities.
In the case of active schemes, the fund manager decides which underlying assets would form part of the portfolio.
Here’s a snapshot:
| Aspect | Active Investing | Passive Investing |
| Management | Actively managed by professional fund managers who make frequent buying and selling decisions. | Passively managed funds are those in which the fund manager is responsible for mirroring or tracking the underlying index. These schemes can also be part of international passive funds that track a specific international index, such as the NASDAQ or S&P 500, providing exposure to a basket of foreign stocks and other securities. |
| Expense Ratio | Typically feature higher expense ratios attributed to the fund manager’s in-depth research, analysis, and management efforts. | Lower expense ratios since no active management or research is required. Passive schemes have a simplified investment strategy and limited involvement of fund managers. |
| Returns | Potential for higher returns if fund managers outperform the scheme benchmark | Returns closely follow the benchmark index performance being tracked by the particular passive scheme, furnishing investors with market-aligned results. |
| Flexibility | Flexible; allows for tactical decisions based on market conditions. | Rigid; funds adhere strictly to the composition of the chosen index. |
| Transaction Costs | Higher due to frequent trading and active portfolio rebalancing. | Lower due to minimal buying and selling of securities. |
What are Index Funds?
As the name suggests, an index fund tracks a market index. Instead of actively selecting stocks or timing the market, an index fund passively tracks the underlying index, buying and holding the same securities proportionally as the index.
For instance, a particular Smallcap Index 100 fund is a type of mutual fund that typically tracks a smallcap-focused index. It represents the performance of the top 100 small-cap companies in the market, ranked by market capitalisation, below the large-cap and mid-cap categories. Thus, the fund will allocate its investments proportionally to all these companies, which means that if a company constitutes 3% of the index, 3% of the fund’s assets will be invested in that company. This ensures that the fund mirrors the performance of the overall Smallcap Index 100.
Note: The above is an example of an imaginary index for the purpose of explaining the methodology and it is not for investment reasons.
What are Exchange Traded Funds (ETFs)?
An ETF is a Mutual Fund scheme traded on stock exchanges, much like stocks. ETFs are designed to track the performance of an underlying index, commodity, or other assets, offering investors an efficient and cost-effective way to diversify their portfolios.
Several types of ETFs are available in India, including Index ETFs, Debt ETFs, Commodities ETFs, Gold ETFs, International ETFs, and more.
ETFs vs Index Funds
Now that we know the meanings of the two passive investing instruments, let’s look at their key differences and similarities. While both aim to replicate the performance of a chosen index, they differ in structure, trading mechanism, and cost considerations.
Investing in index funds or ETFs has its peculiar qualities. For instance, index funds can be purchased directly through fund houses or distributors, and investments can be allowed via SIPs. In contrast, investing in ETFs requires a demat account and a brokerage setup. Here’s more.
Aspect | ETFs | Index Funds |
| Trading Mechanism | Traded on stock exchanges like stocks. Can be bought or sold during market hours. | Purchased or redeemed directly through the fund house, other brokerage platforms, channel partners, and distributors. NAV is calculated at the end of the trading day. |
| Minimum Investment | There is usually no minimum investment required. Instead, the minimum investment is the price of one share of a particular ETF. | Requires a lump sum or SIP. The minimum investment is usually as low as Rs 100, depending on the scheme. However, a few index funds have a minimum investment of Rs 10, too. |
| Expense Ratio | Generally lower than Index Funds, averaging 0.05%-0.2%. | Slightly higher, averaging 0.1%-0.5%, to cover fund management and administrative costs. |
| Liquidity | High, provided the ETF is actively traded. However, some ETFs in India suffer from low volumes. | Redemption through the fund house ensures liquidity, though processing may take a maximum three (3) business days. |
| Costs Beyond Expense Note: Stamp duty is incurred in both index funds and ETFs | Incurs brokerage and transaction charges. | No brokerage, making it simpler for first-time investors. |
| Tax Efficiency | Investors who sell an ETF incur capital gains only on the shares sold. ETFs may also include additional transaction costs due to brokerage and STT (Securities Transaction Tax) on trades. | Taxed as mutual funds—capital gains are based on holding periods (short-term or long-term). |
| Infrastructure Needs | Requires a demat and trading account, limiting accessibility. ETF market prices may fluctuate based on market conditions, investor sentiment and other factors. | No such requirement; index funds can be purchased via mutual fund selling platforms, ensuring broader accessibility. |
| Regulatory Simplicity | SEBI requires market makers for ETFs, increasing operational costs. | No real-time tracking or continuous price updates needed, making index funds operationally simpler. |
Key Takeaway
Therefore, both ETFs and index funds have their advantages and disadvantages. For ETFs, since you can buy and sell units only on the stock exchange, ample sellers and buyers must be available when you want to buy and offload your units to get a good price.
For index funds, units are bought and redeemed directly through the fund house at the end-of-day NAV, eliminating the need for buyers or sellers to match the transaction.
In Conclusion
ETFs and Index Funds are two sides of the same coin. Both offer efficient ways to participate in market growth without the limitations of active management. For Indian investors, the choice comes down to your investment style, portfolio size, and familiarity with market mechanisms.
All in all, passive investing offers a structured approach to wealth building. So, explore the options that suit you the best and your investment goals.
Disclaimers:
An Investor education and awareness initiative by Zerodha Mutual Fund.
Know Your Customer: To invest in the schemes of Mutual Fund (MF), an investor needs to be compliant with the KYC (Know Your Customer) norms and the procedure is -> Fill the Common KYC (CKYC) application form by referring to the instructions given below:
Enclose self-certified copies of both proof of identity and address. For Proof of Identity, submit any one document – PAN/ passport / voter ID/ driving license/ Aadhaar / NREGA job card/ any other document notified by central government. Proof of address, submit any one document which is the same as the proof of identity, except for PAN (since this document does not specify the address). If your permanent address is different from the correspondence address, then you need to submit proof for both the addresses. Documents Attestation – By any one from the authorized officials as mentioned under instructions printed on the CKYC application form. PAN Exempt Investor Category (PEKRN) – Refers to investments (including SIPs) in MF schemes up to INR 50,000/- per investor per year per Mutual Fund. This set of investors need to submit alternate proof of identity in lieu of PAN. In Person Verification (IPV) – This is a mandatory requirement and can be done by the list of officials mentioned in the instructions printed overleaf on the CKYC application form. Please submit the completed CKYC application form along with supporting documents at any of the point of acceptance like offices of the Mutual Fund/ Registrar, etc.
Investors may also complete their KYC online through Aadhar OTP-based authentication. Visit the respective fund house website or contact their customer care to know more about the process.
Modification to existing details like address/ contact details/ name etc. in KYC records – For any modifications to be done to the existing KYC details, the process remains same as mentioned above, except that only the details to be changed needs to be mentioned on the form along with PAN/ PEKRN and submitted with the relevant proofs.
Modification to your existing details like contact details/ name/ tax status/ bank details/nomination/ FATCA etc in Fund House records – Please visit the website of the respective Fund House to understand the procedure to update the details (if published) OR reach out to the customer service team of the respective Fund House.
Dealing with registered Mutual Funds
Investors are urged to deal with registered Mutual Funds only, details of which can be verified on the SEBI website (www.sebi.gov.in) under Intermediaries/ Market Infrastructure Institutions.
Redressal of Complaints
If you have any queries, grievances or complaints pertaining to your investments, you may approach the respective Fund House through various avenues published on their website. If you are not satisfied with the responses provided by the Fund House, you may then register your complaint on SCORES (Sebi Complaints Redress System) portal provided by SEBI for which the link is -> https://scores.sebi.gov.in
Other Disclaimer: The Content of this article/document is for educational and informational purposes only and should not be construed as financial advice. Please consult your financial advisor for advice suited to your specific circumstances.
Investing in mutual funds and other financial products involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should conduct their own research and seek advice from qualified financial advisors to ensure that the respective products and strategies are suitable for their specific financial situation and objectives.
The Nifty and SENSEX indices mentioned in this article/document are owned by NSE Indices Limited and AIPL, a wholly owned subsidiary of BSE Limited respectively. All information provided is for informational purposes only.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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- ETFs vs Index Funds: A Guide to Passive Investing - Dec 31, 2024
