How to ride the upside in benchmark indices

ETFs and index funds invest in stocks that constitute the respective underlying indices

Several stocks have been taking a beating over the past few months. But India’s bellwether indices, Nifty and Sensex, have been scaling new highs, thanks to the strong rally in several of their constituent stocks.

Wondering how to ride the upside in the benchmark indices? Exchange-traded funds (ETFs) and index funds are two options available to you.

 

Both ETFs and index funds are offered by several mutual fund houses that invest in stocks that constitute the respective underlying indices. For instance, Nifty ETF mimics Nifty Index in terms of its portfolio, and likewise a Nifty fund will have the same stocks that form part of the underlying index.

Though the portfolio is the same, differences exist. What are they?

Allocation

While both ETFs and index funds invest in the same set of stocks, the weight of the specific stocks are not the same. The allocation in case of ETFs is closer to that of the index. But in the case of index funds, the allocation can vary compared with the underlying index. This is because index funds have the flexibility to have some portion of the corpus parked in liquid assets and cash to meet redemption requests from investors.

Liquidity

ETFs, as the name suggests, are traded on the exchange and this lends them the liquidity. One can buy or sell ETFs anytime through the exchange, and hence the need for holding cash in the portfolio is eliminated. And this has its pros and cons. For instance, when the market is on a run, ETFs tend to do well, since they are fully invested. However, when the going gets difficult and the underlying index and stocks are on a downward spiral, index funds typically get some respite from the cash they hold as that acts as a cushion during volatile times.

How to buy them?

ETFs, being traded on the exchange, are similar to equity shares. You need a demat account to be able to invest in an ETF. They can be bought online through your broker’s trading platform. If you are considering investing in ETFs for the first time, the first step will be to sign up with a stock-broking platform and open a demat account.

But if you don’t have a demat and broking account and do not intend to open one, index funds are an option for you. These schemes work like any other mutual fund investment. You can either buy them online through the asset management company’s (AMC) portal, MF Utilities portal (shared infrastructure of several AMCs) or through the portal of register-and-transfer agents (R&T) such as CAMS and Karvy.

If you are not tech-savvy, you can just walk into the nearest branch office of a mutual fund house or R&T agent and submit a physical application for the investment. You can also invest through distributors. However, the investment will be in the regular plan of these index funds, which carries a small cost. This is the cost one pays for the advice provided and convenience offered by these distributors.

Returns

The returns offered by ETFs and index funds are different on three counts. One, as discussed above, the cash-holding in the portfolio — which can come handy during volatile times — can also lead to small erosion in gain when the market is on an upswing. Second, the expense ratio in the case of index funds is higher. For instance, HDFC Sensex ETF with an expense ratio of 0.05 per cent has delivered 19.8 per cent in the last one year. HDFC Index Fund - Sensex Plan Regular with an expense ratio of 0. 3 per cent handed out 19.38 per cent gain for the same period, while the direct plan of the same fund, with a lower expense ratio of 0.15 per cent, managed to deliver 19.52 per cent.

While ETFs typically track the returns of the underlying index closer than that of index funds, liquidity and the demand for ETFs do have a bearing on the return. The divergence in the NAV and the traded price of the ETF can be quite wide in the case of ETFs with low liquidity.

Hence, while choosing an ETF, consider those with good liquidity as their NAVs and prices generally move in tandem. Likewise, when you are looking at index funds, pay attention to the expense ratio as it has a significant bearing on the returns.

The writer is co-founder, RaNA Investment Advisors.

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