Equity ETFs and Equity Index Funds Compared
(This
is for information purposes only. This should not be construed as a
recommendation or investment advice even though the author is a CFA Charterholder. Please consult your financial
adviser before taking any investment decision. Safe to assume the author has a vested
interest in stocks / investments discussed if any.)
In investing life, simple products do well. Passive mutual funds are one of the easiest financial products to understand.
With active funds, fund managers have the freedom to invest in a range of stocks or securities selected by managers themselves, subject to the investment mandate of a particular mutual fund scheme or plan.
With passive funds, there is no such freedom for a fund manager to select stocks in a mutual fund scheme. The fund manager does not take a call on individual stocks, instead invests in the stocks that are part of an index in exactly the same weighting as the respective index.
1. Passive funds
In the investing world, there are two schools of thought: One school believes in beating the market and generate excess returns or alpha; and another school thinks you cannot beat the market, as per the principles enunciated in 'efficient market theory.'
People who believe in the former invest in active funds and those who believe in the latter invest in passive funds.
There is nothing wrong with these two approaches; both have their own merits and demerits. Investors have to decide which one to follow, depending on their investment objectives, time horizon and personal situation.
One could say markets can be efficient sometimes and at other times inefficient. Veteran money managers and investors, like, Warren Buffet, Peter Lynch, Terry Smith and Joel Greenblatt have demonstrated the power of active fund management.
But as we have seen in the past 60 years globally, a majority of active funds have been consistently failing to outperform their benchmark indices -- meaning a majority of active funds are unable to outperform the returns generated by passive funds.
Selecting from a plethora of equity mutual fund schemes or plans is a challenge for most of the retail investors. Novice and unsophisticated investors are most of the time better off investing in passive funds.
This blog is written for educational purposes only aimed at retail investors in India and should not be construed as investment advice.
The analysis in this blog is restricted to equity passive funds.
Unlike retail investors, institutional investors have a different investment mandate and are supposed to be more sophisticated compared to retail investors -- they tend to follow an investment approach different from that of retail investors.
(the blog continues below)
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2. ETFs versus Index funds
There are two types of passive funds. One is an exchange traded fund or ETF and another is an index fund. The
speciality of ETFs is they are traded on stock exchanges, like, stocks.
Table 1 compares ETFs and Index Funds:
The main difference between ETFs and index funds: Investors can directly buy ETF products through stock exchanges, unlike index funds which have to be transacted directly through mutual funds.
When
you invest directly in an index fund through the mutual fund, the investor incurs
no trading costs; but while buying or selling ETFs on stock exchanges, an
investor has to bear trading costs, like, brokerage cost, securities
transaction tax (STT) and other taxes, stamp duty and others.
With
index funds, investors can choose to invest in regular or direct plans; and
they have the choice of investing in growth and dividend options too. With
ETFs, investors do not have such options.
Index funds provide the facility of a systematic investment plan (SIP), which is a concept well known as dollar-cost averaging -- whereby investors can invest regularly on a monthly basis Now, mutual funds provide daily SIP facility also.
But ETFs do not provide SIP facility.
Institutional
investors, in general, prefer to invest in ETFs rather than index funds,
because they can do in-kind creation / redemption with minimal cost by directly dealing with the mutual fund.
With in-kind mechanism unique to ETFs, large investors can invest in units of ETFs by paying in cash in exchange for a basket of securities. And the same mechanism in reverse can be used by them for selling / redeeming units of ETFs and receive cash in lieu of units sold.
The creation unit size may differ from one ETF to another. For example, if a large investor wants to invest more than Rs 25 crore in an ETF, say, Bandhan Nifty 50 ETF, she can directly approach the fund house and buy ETF units by paying cash.
3. Portfolio construction
Portfolio construction of a passive fund is easy for a fund manager. The manager just needs to mimic or mirror the stocks underlying an index in the same proportion.
Passive
funds need to match an index that is linked to them. They need to hold
the stocks (or other securities) underlying the index. Passive funds need
to hold the stocks in the same proportion as they are in the underlying
index.
Let us for example consider an ETF named SBI Nifty Next 50 ETF. The ETF's underlying benchmark index is Nifty Next 50. Nifty Next 50 index is a popular index with 50 stocks and its index service provider is NSE Indices Limited.
The ETF needs to invest in stocks proportionately as they are in the index and closely match the return performance of the Nifty Next 50 index.
Table 2: Top 10 stocks in Nifty Next 50 and SBI Nifty Next 50 ETF:
As can be seen from table 2 above, the ETF's underlying stocks are in the same proportion as they are in the underlying index. Only three stocks, namely, Bharat Electronics and TVS Motor Company and GAIL (India) have slightly different weights compared to the benchmark.
Even though there are 50 stocks in the Nifty Next 50 index and the ETF, only 10 stocks are shown in the table 2 above for illustration purpose.
Whenever the index service provider changes the composition of the index, the fund manager too changes the composition of the ETF as per the benchmark, in order to closely match the return performance of the underlying index.
Passive funds are low-cost investment vehicles that provide broad market exposure, portfolio diversification and low portfolio turnover.
As per capital market regulator, Securities and Exchange Board of India or SEBI, the maximum expense ratio index funds and ETFs can charge is 1.00 percent; whereas it's 2.25 percent for open-end equity oriented schemes of active funds.
The risks of investing in passive funds are highlighted here and here. One can also check other various blogs written by the author.
As
at the end of December 2023, the total assets under management (AUM) of
equity passive funds (both equity ETFs and equity index funds) is Rs
6.19 lakh crore as per data from Value Research Online.
4. Comparison of Equity ETFs and Equity Index Funds:
Table 3: List of Select passive funds: Risk metrics, Rating, expense ratios and asset size >
Please click on the image to view better >
Asset size or assets under management (AUM) data in table 3 above are as at the end of 31Dec2023.
Table 4: List of Select passive funds: long-term returns >
Please click on the image to view better >
All the trailing returns data presented in Table 4 above are as at the end of 02Feb2024; and 3-year, 5-year and 10-year data are annualised, that is, they are compounded annual growth rates (CAGR).
Index funds' data in table 4 are for direct plans / growth options. And mutual fund category returns are for direct plans / growth options and they are simple average returns, not asset-weighted.
Table 4 also contains total return (including dividends) data of the underlying indices of the select passive funds. By comparing passive funds' returns with the returns of underlying indices, investors will be able to assess whether the passive funds are able to closely match the return performance of the underlying indices.
Data of a few equity categories, like equity large cap and equity flexi cap, are included to enable readers to see whether active funds are outperforming passive funds.
It may be added funds under equity large cap and flexi cap categories are active funds.
Tables 3 and 4 contain data pertaining to 16 passive funds, eight equity ETFs and eight equity index funds -- based on six equity indices, namely, Sensex, Nifty 50, Nifty Next 50, Nifty 100, Nifty 500 and BSE 500.
The following filters are used to arrive at the above eight passive funds:
(i). funds with AUM of less than Rs 250 crore are removed (only ICICI Prudential S&P BSE 500 ETF is included for comparison purposes).
(ii). funds with less than 3-year record are removed.
(iii). Nifty 50 and Sensex ETFs of SBI MF and UTI MF are removed as they suffer from big investor risk. This is a unique risk (EPFO risk) peculiar to Indian ETFs.
(iv). Thematic, sectoral and international funds are not considered for the analysis.
(v). Bharat 22 and CPSE ETF are ignored as they are based on narrow indices.
There are a number of passive equity schemes based on Sensex and Nifty 50. So is not the case with other indices.
The age of various passive funds is less than five years. When the number of funds linked to an underlying index and with no long-term history, it is hard to assess such passive funds on a long-term basis.
Compared to developed countries, like, the US and the UK, Indian passive funds are fewer in number and are less popular.
5. Observations from return data of Table 4:
> there is not much difference between trailing returns of ETFs and index funds
> the author used to believe equity ETFs were better than index funds -- but after observing the data, especially of passive funds based on Sensex and Nifty 50, one can see there is not much difference between returns of ETFs and index funds on a long term basis.
> passive funds based on Sensex and Nifty 50 are able to closely match the returns of Sensex and Nifty 50 -- the difference is negligible for investors with long term orientation
> as only a few passive funds are available for other indices, like, Nifty 100, Nifty 500 and BSE 500, one cannot assess whether they will be able to closely match the performance of underlying indices
> if you compare the trailing returns of passive funds with those of active funds (large- and flexi-cap funds specifically), active funds have outperformed passive funds as on the date of analysis, that is, 02Feb2024
> but when you compare trailing returns as at end of prior periods, one can say active funds' performance is not superior to that of passive funds
> one could also argue that as Indian equity markets are near their all-time highs, active funds as a category on a trailing basis are outperforming passive funds currently
> the real test for active funds is during market downturns
> as we have seen during the 2008 Global Financial Crisis and prior to and around COVID-19 Pandemic, active funds as a category have consistently failed to generate superior returns versus their passive peers
6. Passive Funds Worth Considering
As argued many times (see equity ETFs worth considering), it is better for novice investors to stick to passive funds based on Nifty 50 and Sensex -- as they provide a lot of funds from different fund houses.
It is not necessary you need to invest only in funds mentioned in table 3 and 4 above -- the list is just for illustration purposes (for a bigger list of passive funds, see raw data in tables 5, 6, 7 and provided below under 'Additional Data').
Based on convenience, time horizon and one's investment objectives, investors can choose between index funds and exchange traded funds (see Section 2 and 3 above).
It may be repeated this blog is just for educational purposes (the author has written more than 400 blogs on a variety of topics in the past 15 years) and should not be construed as investment advice. Investors should consult their own advisers before making any investment decision.
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References and Additional data:
Nifty Passive insights - PDF for Dec2023
NSE Indices return data (including historical data on a specific date)
BSE Sensex total return (Sensex TRI) data
Comparision of all passive funds (equity ETFs and equity index funds) VR
Edelweiss MF converted two ETFs into index funds in Oct2021
Morningstar gives tracking error data in its factsheets and compare weblink
Compare funds ETFs / index funds Tweet 12Jun2021
Compare funds ETFs / index funds Tweet 13Jun2021
Compare funds ETFs / index funds Tweet 13Jun2021
Raw data (from Value Research): Table 5, 6, 7 and 8 >
(trailing returns data are as at the end of 02Feb2024; asset size data at the end of 31Dec2023; equity index funds' data are for direct plans / growth options and simple averages, not asset-weighted)
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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