If you believe that Nifty and Sensex will scale new peaks over the next three-to-five years and are wondering how to bet on them, ETFs and Index funds are the two options that you can explore. Though both are passively managed funds and their returns closely track that of the benchmark, they are not the same. Here are the differences.

How to buy them?

ETFs, as the name suggests, are traded on the exchange and are bought and sold only through the exchange. ETFs being similar to equity shares, you will need demat and broking accounts to buy them. But Index funds can be bought or sold directly from the fund house, similar to other mutual fund schemes.

What about the costs?

Just as brokerage is charged on the value of equity shares that you buy or sell, you will have to pay brokerage when you buy/sell ETFs. But in Index funds you will have to pay an annual management fee. The expense ratio in most Index funds may be upwards of 1 per cent, deductible every year. A fund with a lower expense ratio may be desirable.

Are the returns divergent?

Even as both these funds passively track the underlying index, their returns may be divergent. One unit of an ETF is theoretically equivalent to a tenth of the underlying index value. But that is not always the case. Reason: these being exchange-traded, liquidity has a bearing on the ETF’s value and returns.

In the case of Index funds, the deviation in returns compared with the underlying index can be much higher.

This is because these funds are allowed to hold some portion of their assets as cash — either to meet redemption requests from investors or to cushion against volatility when the markets are turbulent. This can impact returns. Also, higher expense ratio can eat into the scheme’s gains.

Given that the management fee is to be deducted annually, one cannot rule out lower returns for Index funds over the long term, compared with their underlying index and ETFs of the same index.

How to choose?

While choosing an ETF, it is preferable to buy the most liquid ones. If you get stuck with illiquid ETFs, not only will your returns suffer but selling them when you need money may not be an easy proposition.

Likewise, when you are looking to invest in an Index fund, go for the ones with lower expense ratio, because high expense ratio can eat into your long-term returns.

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