Personal Finance

ETFs or open-end index funds?

Aarati Krishnan | Updated on May 19, 2019 Published on May 19, 2019

Given the peculiarities of the Indian market, passive investors need to be extra cautious

With actively managed equity funds struggling to keep up with market indices in the past couple of years, many Indian investors are now keen to give index investing a second chance.

Their first question usually is: What’s a good exchange-traded fund (ETF) to invest in? ETFs, after all, have led the passive investing revolution the world over and are seen as the most efficient vehicles to own a portfolio that simply mirrors an index.

But given the peculiarities of the Indian market, passive investors need to consider another alternative — open-end index funds which can be bought directly from the fund houses. How do you choose between the two?

Product variety

If you’re an investor who likes a Saravana Bhavan-like menu to choose from, ETFs offer a far larger variety of choices than open-end index funds.

The NSE website lists out 53 operational ETFs that track various equity indices. With these ETFs, you can play on different investment styles such as Nifty Quality 30 and Value 20 and different themes such as PSUs, consumption, dividend opportunities and Shariah. You can also invest in the Nifty Next 50, BSE Next 50, BSE Select Midcap and Nifty Midcap 150 indices, with a new BSE 500 ETF making its début recently. There are of course a number of ETFs tracking bellwethers such as the Nifty 50 and the Sensex 30.

With open-end index funds, your choices are far more limited. While there are 24 open-end index funds offered by different AMCs, a majority of these are restricted to the Nifty 50, Sensex 30 or the Nifty Next 50 indices. DSP’s Equal Weight Nifty Fund and Principal’s Nifty 100 Equal Weight Fund are among the very few differentiated products in the open-end space.

Clearly, if you are an informed investor who has a specific style — market cap or theme preference in the market— ETFs may be your only choice to go passive, because index funds don’t offer exotic products. But thematic ETFs require active monitoring and timing, and aren’t well-suited for buy-and-hold investors.

Low costs

The most compelling case for indexing is that you get to make your equity investments at a low annual cost. In India, annual costs (the Total Expense Ratio which includes all management fees, administration and marketing expenses) for actively managed equity funds can go as high as 2.9 per cent a year, taking a big bite out of your returns.

Even within the indexing space, ETFs manage your money at far lower costs than open-end index funds. For instance, the cheapest Nifty 50, Sensex 30 and Nifty Next 50 ETFs in the market charge an annual TER of 0.05 per cent, while the most expensive ones charge 0.25 per cent.

In contrast, the cheapest open-end index funds mirroring the same indices charge 0.20 per cent, with TERs for some as steep as 1 per cent. These are the expense ratios for regular plan investors who rely on an intermediary for advice or transacting. If you take the direct route (you should do it only if you know when and how to invest in equities), the TERs on open-end index funds drop to 0.10-0.70 per cent. Plain-vanilla Sensex and Nifty products tend to be the most economical, while those tracking more exotic indices or themes charge more.

Access

Investing in an ETF requires you to have both a trading account with a broker to buy and sell ETF units and a demat account to hold them in the electronic form. With an open-end index fund, you can buy or sell units directly from the AMC’s website or branch office or through a distributor or registrar. Buying or selling an open-end index fund entails no transaction costs, but on ETF units, you will incur brokerage and Securities Transaction Tax (while selling alone).

Liquidity

When you buy an index product, your main expectation from it is that it will faithfully replicate the returns of the benchmark you’re hoping to track. But in the Indian market, that’s not a given. Both ETFs and index funds often hit you with sizeable tracking errors where their returns vary widely from the underlying index. Factors such as lack of market liquidity, high impact on stock prices when shares change hands in large quantities and frequent changes in the index constituents contribute to this tracking error.

Theoretically, open-end index funds are prone to higher tracking errors than ETFs, because they constantly have to deal with inflows and outflows, requiring the fund manager to incur higher transaction and impact costs. They may also hold cash to meet sudden redemption demands. In ETFs, everyday transactions in the units are between counter-parties on the stock exchange, and do not impact fund management at all.

However, ETF investors in India do have another unpredictable element to factor in — the liquidity of their ETF units on the exchange. The real-time ETF tracker on the NSE website shows that with many ETFs registering thin trading volumes, their market prices trade at discounts of 1-2 per cent to their underlying NAVs. On occasion, the gap between the NAV and the market price distortions can be quite high, with market prices even moving to 10-15 per cent premium to the NAV.

Such distortions when buying or selling can take a big toll on your returns and even rob you of the low-cost advantage that you’re trying to gain through ETF investing. In thinly traded ETFs, you could even end up failing to complete your buy or sell transaction owing to poor volumes on a given day. With open-end index funds, you’re assured of the fund house buying or selling the units exactly at the NAV. This problem makes it quite difficult to execute a monthly SIP in many ETFs, as opposed to open-end index funds.

In short, if you’re simply looking to replicate the market and are a long-term investor, choose the open-end index fund with the lowest TER and start a SIP.

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