Index Funds vs ETFs in India: Which One Should You Buy
An index fund and an exchange traded fund can track the same index, hold the same stocks and still give you a different experience. The index fund is bought from the AMC at one end of day net asset value with no demat account needed. The ETF is a listed security you buy from another investor on the NSE or BSE, at whatever price the order book offers, through a demat and trading account.
For most people investing monthly, the index fund wins on convenience. For a large lumpsum in a heavily traded ETF, the ETF can be cheaper. The gap between those two statements is where the real decision sits.
SEBI’s categorisation rules put both under index funds and ETFs, requiring a minimum of 95% of assets in the securities of the underlying index. So the mandate is nearly identical; the plumbing is not.
The Structural Differences That Actually Matter
| Feature | Index fund | ETF |
|---|---|---|
| Account needed | Folio with the AMC or a platform | Demat plus trading account |
| Price you get | End of day NAV | Live market price, may differ from NAV |
| Transaction cost | Expense ratio, sometimes exit load | Brokerage, STT, bid ask spread, expense ratio |
| SIP | Straightforward, any rupee amount | Possible but clumsy, whole units only |
| Settlement | Units allotted on NAV date | T+1 settlement like shares |
| Typical expense ratio | Low, often higher than the matching ETF | Usually the lowest available |
Tracking Error and Tracking Difference
These two terms get used interchangeably and they are not the same thing. Tracking difference is how far the fund’s return sits from the index return over a period. If the Nifty 50 returned 14% and the fund returned 13.3%, the tracking difference is 0.7 percentage points, and that gap is mostly expense ratio plus cash drag plus rebalancing costs.
Tracking error is the standard deviation of the daily or weekly differences between fund and index returns. It measures consistency, not shortfall. A fund could have low tracking error while steadily lagging by a wide margin, which is worse for you than a slightly noisier fund that lands closer to the index.
SEBI requires index funds and ETFs to disclose tracking error and tracking difference, so both numbers are available in the factsheet. Look at tracking difference first, because that is the money you actually lose.
What causes the gap
- Expense ratio, deducted daily from the net asset value.
- Cash held to meet redemptions, which does not earn the index return.
- Costs of trading during index reconstitution, when a stock enters or leaves the Nifty 50 or Nifty Next 50.
- Dividend receipt timing, since the index assumes reinvestment on a set date.
The ETF Specific Costs Nobody Advertises
An ETF’s expense ratio can be very low, sometimes a fraction of the matching index fund. That headline hides three costs you meet on the exchange.
Bid ask spread
Every ETF has a best buy price and a best sell price. If an ETF quotes Rs 248.10 bid and Rs 248.55 ask, you pay roughly 0.18% just to enter and would face a similar cost to exit. On a large Nifty 50 ETF the spread is usually a couple of paise. On a thinly traded sector or factor ETF it can be far wider, and that one time cost can exceed a year of expense ratio savings.
Premium and discount to iNAV
The indicative net asset value, or iNAV, is published through the trading day and tells you what a unit is actually worth. Market price can drift above it, a premium, or below it, a discount. Authorised participants and market makers are supposed to arbitrage that gap away by creating or redeeming units, but during a fast market or in an illiquid ETF the gap can widen sharply for a while. Comparing the quote against the iNAV before you place an order takes ten seconds and can save you a lot.
Liquidity beyond the big names
Liquidity in Indian ETFs is heavily concentrated. Nifty 50 and Sensex ETFs trade in large volumes because institutions and retirement money use them. Many sector, thematic, factor and international ETFs trade only a few thousand units a day, sometimes with a gap of several minutes between trades. Use limit orders there, never market orders, and avoid placing orders in the first fifteen minutes when spreads are widest.
SIP, Taxes and Practical Choice
Systematic investing is where index funds pull ahead. You can put in Rs 2,500 a month automatically, and fractional units are allotted. An ETF SIP has to buy whole units at market price, so a Rs 2,500 instruction against a unit priced at Rs 248 leaves a remainder, and few brokers automate the process cleanly.
On tax, an equity index fund or equity ETF is treated as an equity oriented fund under the Income Tax Act because at least 65% of assets sit in listed domestic equity, so capital gains follow the equity route. Gold ETFs, international index funds and debt ETFs sit outside that definition and are taxed as non equity products, which is a real difference in outcome. Selling ETF units on the exchange also attracts securities transaction tax and brokerage. Confirm the current rates, since Finance Acts revise them.
- Investing monthly and want it automated: index fund, direct plan.
- Deploying a large lumpsum into Nifty 50 or Sensex exposure: ETF can be cheaper, if you use limit orders.
- Buying a niche theme: check daily traded value first, and prefer the index fund version if one exists.
- No demat account and no intention of opening one: index fund is the only sensible route.
Frequently Asked Questions
Can I buy an ETF without a demat account?
No. ETF units are held in dematerialised form with NSDL or CDSL, so a demat and trading account is mandatory. Index funds need only a mutual fund folio, which is why they suit investors who do not want a broking relationship.
Why did my ETF trade far away from its NAV?
That usually happens when liquidity is thin or the market is moving very fast, so market makers cannot keep the price aligned with the iNAV. It has happened in Indian ETFs during sharp opening moves. Placing limit orders and checking the iNAV before trading protects you from most of it.
Do fund of funds solve the ETF liquidity problem?
A fund of funds holds ETF units on your behalf and lets you invest through a normal SIP without a demat account. The trade off is an extra layer of expense and taxation as a non equity scheme in many cases. It is a workaround, not a free fix.
Which has a lower total cost over ten years?
For a large single investment in a liquid ETF, the ETF usually wins because the expense ratio gap compounds. For monthly investing, repeated spreads and brokerage often cancel that advantage. Compare the expense ratio difference against your expected trading costs rather than assuming.
Key Takeaways
- Both must hold at least 95% of assets in index constituents under SEBI rules.
- ETFs need a demat account and trade at market price, which may differ from iNAV.
- Tracking difference shows what you lost; tracking error shows how consistent the gap was.
- Liquidity outside large Nifty and Sensex ETFs can be thin, so use limit orders.
- Index funds handle SIPs cleanly with fractional units; ETF SIPs are awkward.
