Index funds and ETFs

An index fund and an ETF can hold the identical basket of securities and still be different things to own. The difference is not the portfolio. It is how you get in and out.

An index fund

An ordinary open-ended mutual fund whose mandate is to hold the constituents of an index in their index weights. You buy from the fund and redeem to the fund, at the NAV determined as chapter 4 described.

No manager is choosing stocks. The mandate is mechanical, which is why the expense ratio can be a fraction of an actively managed scheme's.

An ETF

SEBI's definition:

ETFs are mutual fund units that investors can buy or sell at the stock exchange. This is in contrast to a normal mutual fund unit that an investor buys or sells from the mutual fund (directly or through a distributor).

And the structural part, which explains everything else:

In the ETF structure, the mutual fund does not deal directly with investors or distributors. Units are issued to a few designated large participants called Authorised Participants (APs). The APs provide buy and sell quotes for the ETFs on the stock exchange, which enable investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading.

So the fund issues units to a handful of large participants. Those participants quote prices on the exchange. You trade with them, or with another investor, through the order book of chapter 2 of the markets subject.

Two consequences follow immediately, and SEBI states both.

ETFs therefore trade like stocks and experience price changes throughout the day as they are bought and sold.

and

Buying and selling ETFs requires the investor to have demat and trading account.

The price is not the value

This is the point of the chapter.

An index fund transacts at NAV. An ETF transacts at whatever someone will pay, which is a market price — and a market price can sit above or below the value of the underlying units.

It usually does not drift far, and the reason is the authorised participants. If the ETF trades meaningfully below the value of its holdings, an AP can buy units cheaply and redeem them against the basket for more; if it trades above, the reverse. That arbitrage is what keeps price and value together, and it is the same mechanism that keeps NSE and BSE prices in line in chapter 2 of the markets subject.

Three moments when the tether is loosest, all worth knowing:

Thin ETFs. The mechanism assumes someone is doing the arbitrage. In a barely traded ETF the spread can be wide and the price can sit away from value for longer, and chapter 7 of the markets subject is what that spread costs you.

Market stress. When the underlying securities are hard to value or hard to trade, the arbitrage becomes expensive and the gap widens exactly when you most want to act.

When the underlying market is shut. An ETF holding overseas securities trades in Indian hours against holdings whose own market is closed. The price is then a live guess about a stale value. SEBI's NAV timelines register the same problem from the other side: schemes and ETFs with at least 80% in permissible overseas investments have until 10 AM the next day to declare NAV.

So an ETF adds one risk an index fund does not have — the price you deal at — and removes one constraint, since you can trade it through the day rather than at one daily NAV.

Tracking: the gap that is not the fee

Neither vehicle delivers the index return. Both fall short, and the shortfall is bigger than the expense ratio.

Where it comes from:

Expenses, the obvious part, and the smallest for a cheap fund.

Cash. A fund receiving money must hold it briefly before buying. Cash does not track the index.

Rebalancing. When the index changes its constituents, the fund must trade — at prices moved by every other index fund trading the same names on the same day, which is a real cost borne by holders.

Dividends. The index assumes a treatment of dividends; the fund receives them on actual dates and reinvests on other ones.

The discipline: compare a tracker's return with the index's total return version, which includes dividends. Comparing against a price index flatters every fund, because the price index has thrown away the dividends the fund actually received. Chapter 9 returns to this.

Choosing between them

An index fund if you invest monthly, want SIPs to work without thinking, do not have or want a demat account, and would rather transact at NAV than at a price. For most people accumulating over years, this is the straightforward answer.

An ETF if you already trade, want to deal intraday, and the specific ETF is liquid enough that the spread is small. Check the traded volume before the expense ratio: a cheap ETF nobody trades can cost more to get into and out of than a slightly dearer fund.

The point

An index fund is bought from the fund at NAV; an ETF is bought from another participant at a market price that arbitrage keeps near — but not equal to — value, and needs a demat account. Both fall short of the index by more than their fee, so compare against the index's total return version.