Index Funds v/s Exchange traded Funds(ETFs) – What’s good, what’s bad?

So, over the past few days, I’ve been talking about the so-called “Efficient Investment Strategy” – where all my discussion was centered around 2 instruments – Index Funds (IF) and Exchange Traded Funds (ETF). Interestingly, many of the individuals have been asking whether ETF and IF are same or different and if so, what is better. It will be nice to give a QUANTITATIVE difference between the 2, as majority of the individuals believe that IF and ETF are one and the same – which is not the case. Also, I’ll highlight the risks involved for both these instruments, and what all possible ETF and IF are available in India for trading and investment.

I guess all of us are familiar with Mutual Funds. Among Mutual Funds, there are 2 categories – Actively managed and Passively managed.
The Actively Managed Mutual funds are those which are use equity research, stock picking skills and market timing concepts. The fund manager and the team believes that at any given point of time, there are a few over-priced stocks and few under-priced stocks. They attempt to BUY the under-priced stocks and SELL them later when they become over-priced. The fund manager attempts to BEAT THE MARKET by following this strategy. However, as I’ve mentioned in my previous article Should you trust you fund manager, these managers fail miserably as compared to index returns. They may occasionally perform better, but they cannot beat the index returns consistently, year after year. These funds end up paying a hefty salary to the equity research team and also the heavy brokerage commission for frequently buying and selling different stocks, that eats up the profits.
The passively managed funds are those which follow the EFFICIENT MARKET HYPOTHESIS, as I’ve explained in my previous article The Stock Trading Markets: Traders and Market Makers. These fund managers believe that markets are efficient and no one can make above average market returns by actively managing the fund. These managers follow the BUY and HOLD strategy, and attempt to match the market performance by following an index (like Nifty/Sensex /Nifty Junior/etc). Sometimes, they invest the money in a few selected stocks that may not be a part of any index and they hold it for long term, believing that these selected stocks will give better returns in the long run. Ultimately, Passive funds simply follow the BUY and HOLD strategy.
Now, Index Funds are special types of PASSIVELY MANAGED funds that strictly replicate a particular index and buy only the stocks that are a part of that index. Not only that, they also rebalance their portfolio with respect to the performance of the stocks in the index, on a regular basis.
Let me repeat the example of and index constituent:
Suppose an index contains two stocks A and B. A has a market capitalisation of Rs.1000 crore and B has a market capitalisation of Rs.3000 crore. Then a weight of ¼ is attachd to movements in A and 3/4 to movements in B. This is known as weighted averaging and is calculated as follows:
Total of two companies: 1000 + 3000 = 4000.
Weighted average of A = (Value of A)/(Total of 2 companies) = 1000/4000 = ¼ = 25%
Weighted average of B = (Value of B)/(Total of 2 companies) = 3000/4000 = ¾ = 75%
Hence, if there is a 10% increase in A and a 5% decrease in B, the index value will change by (+10%)*1/4 + (-5%)*3/4 = -1.3%.
So let’s say a new index fund has started today which is replicating the above index (with only 2 companies A and B). Say it was able to collect 1000 crore Rs. from the market through New Fund offer (NFO). Since the weight in A and B in the index, as of today is ¼ and ¾ respectively, the index fund will invest 250 Crores in stock A and remaining 750 crores in B. This way, the fund is attempting to replicate the index which it is following. Suppose the fund manager rebalances the portfolio after every 15 days. After 15 days, due to price changes in the stock price of A and B, we have the following situation:
Value of A: Increased to 1200 Crores
Value of B: Decreased to 2700 Crores.
Total of Index = 3900 Crores
Weighted average of A = (Value of A)/(Total of 2 companies) = 1200/3900 = 30%
Weighted average of B = (Value of B)/(Total of 2 companies) = 2700/3900 =70%
So now, the fund manager will buy additional 5% stocks of A and sell 5% stock of B, such that he is able to keep his fund exactly on track with the index.

Benefits of Index Funds:

The major benefit of Index funds is that you go with the market (atleast). If the so called index is up, you are with it, and if it is down, you are with it. As compared to a Mutual fund, this helps both in good times and slack times.
Another major benefit is that since these funds are NOT actively managed, they save a lot on research cost and also stock selection. Hence, these funds are supposed to have a LOW Entry/Exit load. However, in India, these funds are still in infancy so some of these funds may charge higher commission, but the trend is changing rapidly. Internationally, as compared to a Mutual fund management fee of 3-4%, index fund fee is in the range of 0.2-0.5% only, which simply translates to better savings and more returns. This becomes significant during the bear markets, as the actively managed funds not only loose money, but they also charge dearly on commission, while index funds atleast have low expense ratio, thus more savings.

What do you loose by investing in Index Fund?
You may loose the so called mid-cap gainers, which may perform much-much better than the overall market. It is true that in the short run, some MFs may perform better than index fund. However, historically, it has been proven that no active fund manager can consistently select only the winning stocks. A study shows that 10,000 $ invested in S&P 500 index fund in 1969, would have yielded $310,000 (31 times increase) in 1999, while the same $10,000 invested in the BEST performing Mutual fund would have yielded only $171,00 (only 17 times increase). Another way to take advantage of mid-cap gainers is to invest in Index Funds following the Mid Cap Indices.

Here is the list of Index funds available to the traded through NSE:
• IDBI Index I-NIT’99, an index fund scheme on S&P CNX Nifty launched by IDBI - Principal Mutual Fund in July 1999.
• UTI Nifty Fund launched by Unit Trust of India in March 2000.
• Franklin India Index Fund launched by Franklin Templeton Mutual Fund in June 2000.
• Franklin India Index Tax Fund launched by Franklin Templeton Mutual Fund in February 2001.
• Magnum Index Fund launched by SBI Mutual Fund in December 2001.
• Prudential ICICI Index Fund launched by Prudential ICICI Mutual Fund in February 2002.
• HDFC Index Fund – Nifty Plan launched by HDFC Mutual Fund in July 2002.
• Birla Index Fund launched by Birla Sun Life Mutual Fund in September 2002.
• LIC Index Fund – Nifty Plan launched by LIC Mutual Fund in November 2002.
• Tata Index Fund launched by Tata TD Waterhouse Mutual Fund in February 2003.
• ING Vysya Nifty Plus Fund launched by ING Vysya Mutual Fund in January 2004.
• Canindex Fund launched by Canbank Mutual Fund in September 2004
• Reliance Index Fund launched by Reliance Mutual Fund on Jan 2005
• Principal Junior Cap fund launched by Principal PNB on May 2005

In essence, index funds are like mutual funds, where they invest only in index composed stocks and you can encash them anytime, as you encash your units in a Mutual fund.

Exchange traded Funds or ETF’s:

An ETF, contrary to an Index Fund, is NOT a Mutual Fund. Instead, it can be thought as a STOCK, where the STOCK can be traded openly on the exchange, yet it gives the benefits of diversification as 1 single such ETF STOCK consists of several different bits of stocks listed in a particular index.
Since they are treated like stocks, you can buy them with a small amount of money, you can even SHORT SELL them, even buy them on margin and pay only the commission for a single trade, just like the brokerage of a stock buy/sell trade. ETF’s are introduced by a financial organization, most likely by a bank or fund company. They are OPEN-ENDED funds, hence new shares can be created by the fund company, based upon the demand. They also offer tick-by-tick pricing throughout the trading session, so they can be traded for small profits multiple no. of times. Index funds do NOT have this feature, they value at the end of the day with a Net Asset Value, NAV. The expense ratio for these funds is lower and all you have to pay is the brokerage (like buying a stock), while IF can have entry load, exit load, Management commission, distribution costs, etc. though all these charges are quite less. It is possible to see ETFs having higher charges than IF’s and the other way round. It is better to look at the fine prints of the commissions charged before jumping in.

Here is the list of ETFs as available on NSE:
• NIFTY BeES an Exchange Traded Fund launched by Benchmark Mutual Fund in January 2002.
• Junior BeES an Exchange Traded Fund on CNX Nifty Junior, launched by Benchmark Mutual Fund in February 2003.
• SUNDER an Exchange Traded Fund launched by UTI in July 2003.
• Liquid BeES an Exchange Traded Fund launched by Benchmark Mutual Fund in July 2003.
• Bank BeES an Exchange Traded Fund (ETF) launched by Benchmark Mutual Fund in May 2004.
• Benchmark Split Capital launched by Benchmark Mutual Fund on August 2005
• UTI Gold Traded ETF

One major benefit of ETF’s over IF’s is that they can be traded in real time. Index funds however, have a time lag, as they rebalance their portfolio once in a while. Suppose you have an IF on Sensex and an ETF on Sensex. Suppose Sensex touches a record high of 15000 at 12 noon, so you may immediately sell the ETF to maximize profits. While in the case of IF, you will have to depend on the end of the day calculation of IF NAV, and if the Sensex goes down from 15000 at 12 noon to 14500 at 3:30, then your IF NAV will be loosing. Situation will be worse if the fund manager balances the portfolio quite later, say every 15 days or every month. If the changes happen on 1st, and the IF manager balances it on 15th or 30th, then there is a substantial lag and therefore a loss. ETFs can be traded in real time. However, it is important to note that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or more difference between the actual index's year-end return and that of an ETF – this actually amounts to the trading activities on ETFs.
Have a look at the graph below showing the total assets in Mutual Funds, Index Funds and ETFs. The graph clearly shows a very big growth in ETFs investments, as compared to MF’s and IF’s.
Selection of IFs and ETFs is hence dependent on an individuals choice and priorities. However, as a salaried individual or businessmen, I am averse to trading. The benefits of ETF’s and IF’s will be observed only when you keep your investments for a long term. In the short term it is possible that a few MF’s or individual stocks may perform better than ETF’s and IF’s, but in the long run, it is these 2 types of securities that prove to be worthwhile.