Index MFs vs ETFs

This post is not financial advice!

These are merely notes I made for myself when I was deliberating over whether to choose Index Mutual Funds or Index ETFs for long-term investments and financial planning. Most of these are quotes (in yellow) compiled from the various links shared at the bottom of the post, with some notes from my end where relevant.

Also do note that this post does not cover any topics about whether index investing good, or relevant for you, etc. It only very narrowly focuses on choosing between them IF you have already decided on pursuing a passive index strategy for part of your portfolio.

Factors that affect your choice

Liquidity and Redemption

When you buy an index fund from an AMC it adds to the AUM of the Fund and when you redeem your units the AUM reduces. The net effect each day will either increase or decrease the AUM. For an Index ETF you can buy or sell only if there is counterparty to the trade. So, liquidity is the key in index ETFs and their AUM will only increase when the value of the shares goes up.

[My Notes] When I think of this from a long-term (15+ year) planning view, I worry that purchasing ETFs will cause me to accumulate a large amount of units by then, and selling might be difficult if counter-parties/liquidity is an issue. On the other hand, index funds do not have this problem (assuming we trust the AMC to not go belly up or perpetrate some form of fraud).

Systematic Investments and Dividend Reinvestment

Index funds score over index ETFs in the sense that you can structure a systematic investment plan (SIP) in an index fund. SIP has emerged as the most popular method of investing for retail investors. This gives the added benefit of rupee-cost averaging which lowers the average cost of owning the units. Since index ETFs are closed ended, the benefit of automated SIPs are not available to you. This is an area where index funds score.

[My Notes] One workaround to do “SIP"s in ETFs is via the stocks SIP feature in Zerodha (and perhaps equivalent featuers in other apps). This can work, but there are two drawbacks:

Unlike SIPs where you specify the amount to invest, Zerodha stocks SIP requires you to specify how many units you wish to purchase, so your amount varies over time
Since you don’t know what the price is going to be, you’ll be forced to place market orders, which is a bad practice for ETFs because they can be pretty volatile.

Since ETFs are like traded stocks, the dividends are directly credited to your registered bank account. This is a hassle from a financial planning point of view as the dividends have to be manually reinvested. In case of index funds, you can opt for a growth plan where dividends are automatically reinvested.

Price and Cost

An index fund purchase or redemption will be executed at the end-of-day (EOD) NAV. The NAV is the net asset value based on the market value of all stocks adjusted for the total expense ratio (TER) on a daily basis. On the other hand index ETF prices vary on a real time basis and the price also keeps changing frequently.

The big advantage in favour of an ETF is that the Expense ratio in an Index ETF is much lower than an index fund. In India generally index fund has an expense ratio of 1.25% while index ETFs have an expense ratio of about 0.35%. That is just the TER that is debited to the index ETF. In addition, when you buy and sell the index ETF you are also liable to pay the brokerage and other statutory costs like GST, STT, stamp duty, exchange fees, SEBI turnover tax etc.

[My Notes]

First (in favor of Index MFs): The 1.25% TER might be so for regular Index MFs. Direct Index MFs would have much lower TERs (maybe 0.2-0.3% over the equivalent ETF TERs? Approx guess). So I don’t think the comparison between 0.35 vs 1.25 is fair. MFs are probably more expensive, but I assume not by THAT much.
Second (in favor of ETFs): I previously mentioned “market volatility” not being good for market orders etc. Let’s say purchasing ETFs is more expensive because you’re placing market orders. Let’s say that the purchase cost turns out to be equal to (or even marginally higher) than the equivalent Index MF NAV. Even then, this premium is one-time. Whereas the expense ratio difference (Index MF TER minus ETF TER) is annual and it compounds, so ETFs might end up net better in performance over a long period regardless of higher cost of purchase.

Taxation

On the taxation front, there is not much to choose between the two.

My Decision (as on Feb 2022)

Here’s my profile as an investor

I know that I am not a sophisticated investor, I don’t understand many intricacies. And frankly, I don’t want to, there are far more interesting things to do in life (at least that’s my opinion as on the date of writing).
I hate having to think about investments, and want to do as little of it as possible. I want to have an automated “fire and forget” strategy (with periodic reviews) instead of having to do things every week/month.
I have no interest in extracting every last paisa of return from my investments because that causes me to get into analysis-paralysis and I end up having the money sitting in my savings account instead of earning anything at all. I have also evolved into the “pay experts to do what they do best” mentality, so I can consider the extra 0.2% as cost of convenience / enforced discipline.

Final Decision

Based on the above about my profile, I intend to go with Index MFs, at least for the time being until I become a bit more sophisticated as an investor.
I will also probably revisit this decision in a few years as I learn better (I will hopefully write a post again then, but I don’t commit to it)

Bhumil Haria