Index Fund vs ETF: Which One Should You Choose?

What is an ETF?

An Exchange Traded Fund is an investment vehicle composed of a mix of assets like bonds and stocks and directly traded on a market exchange. Moreover, it can be tailored to offer exposure to various market segments, such as sector or asset class.

Their main motive is to track the performance of a market segment, or, you can say, index, which helps enhance their appeal to the average investors looking for market returns with the benefit of diversification. Furthermore, ETFs follow the market, but other investments, like mutual funds, aim to beat the market.

If you talk about the benefit of ETFs over other funds, it is that they can be traded like stocks. These traded funds are transacted as soon as possible once they are submitted for execution. On top of that, they are passively managed and have low operating costs that deliver higher returns to almost every investor. 

Additionally, ETF vs index funds are of higher liquid and offer tax advantage wherever they are applied. 
 

Define Index Fund?

An index fund is a kind of mutual fund with a portfolio constructed that perfectly matches or tracks the various components of a financial market index like the Standard & Poor's 500 Index. With the passing of time, this index mutual fund delivers broad market exposure, low portfolio turnover, and low operating expenses. 

These index funds are best considered for core portfolio holdings like retirement accounts, such as individual retirement accounts and 401 (k) accounts. According to Legendary investor Warren Buffett, index funds are one of the greater havens for savings for later years of life. He said rather than picking out individual stocks for investment index funds, it is best for the average investor to buy all S&P 500 companies at a very low cost. 

Index funds are a type of passive fund management system in which a fund manager builds a portfolio whose holdings mirror the securities of any of the particular indexes. Moreover, the portfolios of index funds change suddenly when their benchmark indexes change. 

That means if any of the funds follow a weighted index, its manager will periodically rebalance the overall percentage of varied securities that reflects the weight of their presence in the benchmark.
 

What do Index Funds and ETFs Have in Common?

Both indexes vs ETFs are bundled together in a number of individual investments like stocks or bonds like a single investment. This is the main reason it is one of the popular choices among investors for a number of reasons. They are: -

●    ETF vs index fund helps to create a well-diversified portfolio.
●    They are passively managed, which means the investments within the fund are directly based on an index like S&P 500. 
●    They are the best for long-term investors as they outperform actively managed mutual funds. No doubt they follow the ups and downs of the index during tracking but overall show positive returns. 

Mutual funds that are actively managed always perform in an excellent way in the short term as fund managers make great investment decisions based on current market conditions and as per their experience. 
 

Differences Between ETFs and Index Funds

After reading the above post about an ETF or Index Fund, you might get an idea of what they are. But to know more, there are many other differences which will help you to understand both of them in a better way. They are: -

1.    The minimum investment required

In most cases, ETFs have very low investment as compared to index funds. The reason is they are traded like stocks and are purchased as whole shares. That means you can buy an ETF for the price of just one share, which is known as the ETFs market price. 

But if you talk about index funds, brokers rarely offer a bit higher price than any of the typical share prices. So, if you are planning to invest a minimum amount, always go for an ETF over an index fund with your own share price which is affordable. Moreover, looking to go with an index fund is also a great option without investment. 

2.    The capital gains taxes you’ll pay

Here if you talk about ETFs, it delivers tax benefits as compared to index funds, and this credit goes to its structure. That means if you plan to handover an ETF to any other investor, the money will come directly from that investor. In short, the capital gains taxes with the selling of the ETF will be yours.

But in an index fund the owner has to redeem this cash directly from the manager and they will take your securities to produce money for you. In this process, the net gain is passed to each investor that has shares in your fund. That means,  you will not get capital gains money without selling even one share. 

Overall, ETFs deliver more benefits than Index Fund.

3.    The cost of owning them

In regards to cost, both ETFs or index funds are very easy and affordable to own in the context of expense ratio. That means it can cost you a minimum amount than 0.05% of total investment annually. 

But there is another cost which you have to pay while buying an ETF and index fund in trading commissions. But, if you are interested in ETFs, the broker will take some charge as a commission for trades when you purchase or sell an ETF, which will again turn into returns if you are trading regularly.

No doubt, in the case of index funds also you have to pay some transaction fee while buying or selling, but there is a difference in the cost, which you have to consider before choosing one. In short, both of them are low-cost options as compared to various other mutual funds, but you have to compare the expense ratio of both before selecting one. 
 

Investment Structure

Understanding the investment structure of ETFs and Index Funds helps in evaluating how your money is allocated, managed, and grown over time.

ETFs Investment Structure:

• Creation and Redemption: ETFs are structured through a creation and redemption mechanism involving authorized participants (APs). These APs can create new ETF units by delivering a basket of underlying securities to the ETF provider or redeem ETF units in exchange for the securities.
• Real-Time Trading: ETFs trade like stocks on exchanges and prices fluctuate throughout the day. The fund's value is influenced by the real-time net asset value (iNAV), supply and demand, and market speculation.
• Liquidity and Settlement: Because ETFs are traded on exchanges, they benefit from the liquidity provided by market participants. Settlement usually occurs within T+2 days, similar to stock transactions.
• Market Makers: ETFs often have market makers who ensure that the ETF unit price remains close to its NAV by arbitraging any price differences between the ETF and its underlying assets.

Index Funds Investment Structure:

• Fund Management: Index Funds are managed by Asset Management Companies (AMCs) that collect money from investors and buy securities that mimic the composition of a specific index.
• Daily NAV Calculation: The Net Asset Value is calculated at the end of each trading day. Investors buy or redeem units based on this NAV.
• Pooling Mechanism: Investors’ funds are pooled together and invested proportionally across all the stocks in the index. This structure does not allow real-time trading.
• No Intermediary Traders: Unlike ETFs, Index Funds are bought or sold directly through the fund house or via mutual fund platforms without the involvement of authorized participants or market makers.
   

Taxation on Exchange-Traded Funds vs Index Funds

Taxation is a crucial factor for investors looking to maximize their returns. While both ETFs and Index Funds can fall into equity-oriented or debt-oriented categories, taxation rules are based on the nature of the underlying securities.

Equity-Oriented ETFs and Index Funds (more than 65% equity exposure):

• Short-Term Capital Gains (STCG): If units are sold within 12 months, gains are taxed at 15%.
• Long-Term Capital Gains (LTCG): If held for more than 12 months, gains up to ₹1 lakh per year are tax-free. Gains exceeding ₹1 lakh are taxed at 10% without indexation benefits.

Debt-Oriented ETFs and Index Funds (less than 65% equity exposure):

• Short-Term Capital Gains: Gains from holding period of less than 36 months are taxed according to your income slab.
• Long-Term Capital Gains: Gains from holding period of more than 36 months are taxed at 20% with indexation benefits.

Dividend Taxation:

Earlier, dividends were taxed at the source through Dividend Distribution Tax (DDT). However, under the new tax regime, dividends are now taxed in the hands of investors as per their income tax slab. Both ETFs and Index Funds are subject to this treatment.

Securities Transaction Tax (STT):

• ETFs: STT applies when ETFs are bought or sold on stock exchanges.
• Index Funds: STT is generally applicable on redemption.
   

What Do ETFs and Index Funds Have in Common?

Though different in structure and trading, ETFs and Index Funds share a number of core investment principles and benefits:

• Passive Strategy: Both are passively managed, tracking specific indices instead of trying to beat the market.
• Diversification: Both offer exposure to a broad basket of securities, which helps reduce risk by spreading investments across sectors and stocks.
• Lower Expense Ratios: Because they aren’t actively managed, the costs of managing these funds are lower than those of actively managed mutual funds.
• Market Performance Tracking: Investors can earn returns that closely mirror the index they’re tracking, providing a transparent and predictable outcome.
• Good for Long-Term Goals: Both are suited for long-term wealth creation due to consistent market exposure and lower costs.
• Ideal for Beginners: Their simplicity and reduced risk make them excellent entry points for new investors.
• SEBI Regulations: Both products are regulated by SEBI, ensuring a level of safety and standardization for Indian investors.
   

Conclusion

Index Funds and ETFs serve the same purpose of replicating an index, but they differ in structure, accessibility, trading, and taxation. The decision between investing in ETFs or Index Funds should align with your personal financial goals, investment knowledge, and preferred mode of operation.

Go for ETFs if:

• You have a Demat and trading account.
• You are comfortable with real-time trading.
• You prefer slightly lower expense ratios.
• You want flexibility in buying and selling at any time during market hours.

Go for Index Funds if:

• You are new to investing or want a simpler route.
• You wish to automate your investments through SIPs.
• You don’t have a Demat account and prefer ease of access through mutual fund apps or platforms.
• You are investing for long-term goals like retirement or children’s education.

Both options are efficient, low-cost investment vehicles. By understanding their structure, tax implications, and key similarities, Indian investors can make informed decisions and build wealth in a disciplined, market-linked manner. Whether you're a seasoned trader or a first-time investor, both ETFs and Index Funds deserve a place in your investment portfolio.