Passive funds have gained a lot of popularity, with many studies suggesting that a majority of the fund managers do not outperform the market. The two most common products that come to mind for passive investing are Index funds and more recently the ETFs.
Both Index fund and ETFs try to replicate an index by holding stocks in the same proportion as the Index. Index funds and ETFs have certain unique futures which make them suitable for different investors based on their needs. ETFs are usually associated with being as a low-cost alternative, but this might not always be the case.
The U.S. based Vanguard group provides a cost comparison analysis for all its ETFs and Index funds to give the investor a clear picture on which would be suitable to them. However, I have not come across such a comparison when it comes to the funds in India. So let’s compare ETFs and Index funds purely based on a cost basis in the Indian context. I have used SBI ETF Nifty and SBI Nifty Index fund (direct plan) for this analysis.
The only cost associated with an Index fund is the expense ratio, whereas for an ETF in addition to the expense ratio we have the trading cost, and the bid-ask spread as one needs to buy it directly through a stockbroker from a stock exchange. Trading cost involves the brokerage and other taxes.
(The trading cost includes brokerage and this will varies for different users. I have taken it as 20 bps for this analysis)
Investment amount: 100 Rs Expected annual return on Nifty: 10%
Based on this cost and the expected return, the total cost of holding the SBI Nifty ETF and SBI Nifty Index fund would be as below.
We can see from this analysis that an ETF becomes less expensive than an Index fund only if the holding period is at least five years. This is contrary to popular perception that ETFs are a low-cost option when compared to Index funds. By just looking at the expense ratio, it would always seem that ETFs are less expensive than Index funds, but we need to take into account the other costs associated with ETFs as well.