Regular index funds vs direct funds: Are ETFs better than index funds? | Personal Finance

The person who pioneered the concept of Index funds was John C Bogle. He started the Vanguard Group in the 1970s and went on to popularise index investing. The concept was clear—mirror the benchmark index, buy what they buy, sell what they sell.

This also meant there was no need for a research division or active fund management. This resulted in significant cost savings, which alone enabled it to outperform many actively managed mutual funds.

The cost structure plays an important role. If we consider two funds: Fund A returns 14 per cent annually with a 3 per cent cost structure, and Fund B returns 12 per cent annually with a 0.5 per cent cost structure. The winner turns out to be Fund B.

The reason is that the final returns the investor gets from Fund A = (14–3 = 11 per cent) and Fund B = (12–0.5 = 11.5 per cent). Even if Fund A ended up achieving 200 basis points of outperformance over Fund B, it gave away more money to expenses.

This was the only reason why Index Funds continued to beat more than 70 to 80 per cent of all active funds in the US. In India, 65 per cent of large-cap funds fail to beat the Nifty Index fund. This outperformance is not due to the incompetence of the active fund managers but rather to costs. However, the story is quite different in the small-cap space, as active fund managers continue to beat passive index funds—a trend that could be due to their stock-picking skill sets.

Index funds come in two variants—Regular and Direct. Regular mutual funds are the ones you purchase through mutual fund distributors, and they are usually in the SOA (Statement of Accounts) format.

Whereas, Direct mutual funds are those you purchase directly from a broker, usually in Demat form.

The cost structure of regular mutual funds is higher than that of direct mutual funds because they pay commissions to distributors.

Mutual Fund Distributors (MFDs) play an important role in market development. In a country like India, where the majority prefer to invest in Fixed deposits, you need someone like the MFDs to nudge them to shift to mutual funds.

Hence, the Asset Management Companies (AMCs) pay them dearly as commissions for getting them these clients.

Secondly, stock markets are inherently unpredictable. Sometimes it goes up and otherwise down. This means investors could see their investments fluctuate in value, often scaring them.

This is where the MFDs provide them with strong support and reassurance. Having seen multiple market cycles, they would guide their customers to stay invested. AMCs also reward MFDs for this by continuing to pay them trail commissions if the investor does not redeem.

Direct mutual funds were introduced in 2013, allowing you to bypass distribution costs.

As of now, around 45 per cent of all Assets Under Management (AUMs) are in direct form, resulting in better results than their regular counterparts. This percentage is expected to grow as more investors become tech-savvy and realise the cost benefits it offers. Some brokers offer both regular and direct mutual funds to their clients, giving them a choice.

In India, the most popular index fund is the Nifty Index fund that replicates the Nifty50 benchmark. Nifty50 has 50 stocks, and the weightage of the top components is as follows. HDFC Bank has a 10.94 per cent weight, meaning when you invest ₹100, ₹10.94 goes to HDFC Bank. Reliance has 8.87 per cent, which translates to ₹8.87 out of 100, and ICICI Bank has 8.42 per cent, which becomes ₹8.42 out of ₹100, and so on.

When you invest in a Nifty Index fund, it automatically purchases the stocks in the exact percentage as shown in the table. The AMCs do not require an exclusive research division to handle the stock picking or rebalancing, per se. Hence, the costs are drastically lower.

Nippon India Nifty Index Fund (Regular) has an expense ratio (costs) of 0.41 per cent versus an expense ratio of 1.5 per cent for Nippon India Large Cap Fund. You can noticeably see the price advantage of index funds as their expense ratio is 72.6 per cent lower than that of an actively managed fund. It also means the active fund has to generate an additional return of 1.09 per cent (1.5–0.41) over the passive fund to give surplus to its investors.

When you opt to invest via the direct plan, the cost benefits are immense. The same Nippon India Nifty Index Fund (Direct) has an expense ratio of only 0.07 per cent, compared with 0.41 per cent on the regular route. A whopping 83 per cent drop in the costs. To appreciate the magnitude, you need to understand the difference it could create in a 30-year period.

If you invest ₹10 lakh as a lump sum for 30 years via the regular route, it would grow your corpus to ₹3 crore, assuming 12 per cent annual returns. The same money invested in the same mutual fund in the direct route will grow to ₹3.28 crores. A difference of ₹28 lakh.

If you choose to invest directly, you will need a demat account. All modern-day brokers provide free demat accounts with an intuitive mobile app. The advantage of demat accounts is that you can invest in multiple brands (AMCs) with a single login. Some investors would prefer to invest in SBI MF, HDFC MF, ICICI MF, Nippon MF, etc., at the same time, and a demat account can handle this perfectly.

Index funds are not limited to the Nifty or Sensex Index. There are many sectoral indices, such as Next-Nifty, Midcap-150, Smallcap-250, Nifty-100, BSE 500 Index, etc.

ETFs (Exchange Traded Funds) are the newest addition to the table. They are passively managed mutual funds, but they can be traded like a stock. ETFs have a lower cost structure than direct mutual funds because investors execute buy/sell transactions directly, and AMCs do not have to handle inflow/outflow calculations (to an extent). ETFs work like stocks, and AMCs handle the quantity directly with brokers, whereas in direct mutual funds, AMCs have to track the quantity and NAV (net asset value) for each customer.

If we use the same example, Nippon Nifty Index Fund (Direct) has an expense ratio of 0.07 per cent, whereas its ETF NIFTYBEES has an expense ratio of only 0.04 per cent, a 42 per cent reduction in costs.

If we compare the Nippon Nifty Index Fund (Regular) (0.41 per cent) to the Niftybees (0.04 per cent), the cost savings are a whopping 90 per cent. A lump sum of ₹10 lakh for a period of 30 years would have returned an additional ₹31 lakh, assuming 12 per cent annual returns.

Since ETFs can be traded like stocks, they offer a lot of flexibility in portfolio creation and rebalancing. Portfolios are nothing new; it is just that you are segregating all your holdings, so that the weightage of each security is monitored and controlled. This helps in diversification.

For example, if you buy just 2 or 3 stocks, the downside risk could be huge as the collection of these stocks may not provide you with the necessary diversification. When you buy independently, you may not even know the individual weight of these stocks in your total investments. The solution is to combine the purchases into a basket that reflects each stock's proportional weight.

For example: If you have 3 stocks, ABC for ₹10 lakh, DEF for ₹4 lakh, and GHI for ₹3.5 lakh, when you convert it to a basket, it would look like this: Stock ABC with 57.14 per cent weight, DEF = 22.86 per cent, GHI = 20 per cent. This makes it relatively easy to manage and rebalance.

The advantage of ETFs is that they can be added as stocks, and their weights can be assigned. For example, let us assume that the three stocks you held were in the large-cap space, and you wish to allocate an additional 12 lakhs to the midcap 150 index. The best solution is to add a mid-cap ETF to your holdings. The revised portfolio will look like this, and you can quickly see that the midcap ETF accounts for 40.68 per cent of your total investments.

Similarly, you can customise your portfolios in n different ways. The limit is your creativity. I have created similar baskets for multiple clients as per their requirements.

For example, one of the clients required that 65 per cent of his investment go to the small-cap space and 35 per cent to the mid-cap space. Another client asked me to design a portfolio with a 15 per cent allocation to gold, 40 per cent to large-cap, and the remainder to mid-cap.

Hope you got the idea. ETFs allow you to ultra-customise your percentage allocation to asset classes. As an individual, you are getting a similar feeling of how professional fund managers buy, maintain, and rebalance portfolios.

If you wish to participate in the stock market but do not have the time or inclination to research it, index funds or ETFs are best for you. You are getting a complete market exposure and participating in India’s growth story. If Nifty goes up, your fund also goes up. If Nifty falls, your fund will also fall. You need not hand-pick stocks or time the market; just follow the benchmark.

This type of investing is called passive investing. If you have self-control and discipline, the best way to invest is through direct investing or ETFs, but if you lack discipline, you might have to go through a mutual fund distributor.

ETFs are not limited to the Nifty or Sensex Index. There are many sectoral ETFs, such as Gold, Silver, Nifty IT, Nifty Bank, Small-Cap Index, Mid-Cap Index, Momentum Index, Quality Index, etc. The ETFs are not available for investment through the regular route (via MFDs); instead, they are offered through FoFs (Funds of Funds). For example, HDFC has a Gold ETF FoF, which is nothing but a mutual fund that manages its Gold ETF.

The commissions you pay out to the MFDs are nothing compared to the support and effort they take to grow your money. In fact, they are more concerned about your capital than you are. However, if your primary goal is to save on costs, I would always recommend choosing a direct index fund or an ETF.

The writer is a SEBI Registered Investment Adviser (INA000021757), SEBI Registered Research Analyst (INH000025054), and author of ‘How to join the top 1% options traders club’.

DISCLAIMER: Investments in the securities market are subject to market risks, including the potential loss of principal. Past performance does not guarantee future results. Information provided is for educational purposes only and should not be considered financial advice. Investors should read all related documents carefully and consult a certified advisor before investing. Registration granted by SEBI and Enlistment with RAASB/BSE and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. The investor is requested to take into consideration all the risk factors before actually trading in stocks or derivatives.

The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.