ETFs vs. Mutual Funds in India: How They Actually Differ

An exchange-traded fund (ETF) and a mutual fund can hold exactly the same portfolio. A NIFTY 50 ETF and a NIFTY 50 index fund, for example, both aim to own the 50 companies in the index in the same proportions. In India, both are mutual fund schemes regulated by SEBI and run by asset management companies (AMCs). So why do both exist, and how do you choose between them? The answer lies in the mechanics of buying, selling, and holding them.

How you buy and sell

A regular (non-ETF) mutual fund is bought from and sold back to the AMC itself, directly or through a platform or distributor. You do not need a demat account. Your purchase or redemption is processed at that day's net asset value (NAV), which is calculated once, after the market closes. Whether your order gets that day's NAV or the next day's depends on cut-off times and when your money reaches the fund.

An ETF is listed on a stock exchange such as NSE or BSE. You buy and sell its units through a broker during market hours, just like a share, and you need a demat and trading account. The price changes through the day and is set by buyers and sellers on the exchange, not by the AMC.

The price you pay: NAV, market price, and spreads

With a mutual fund, everyone transacting on a given day gets the same NAV. With an ETF, the price you pay depends on what other traders are willing to accept at that moment. Two frictions follow from this.

• Premium or discount to NAV. An ETF's market price can drift above or below the value of its underlying holdings. AMCs publish an indicative NAV (iNAV) during the day so you can compare. Large, popular ETFs usually trade close to it; thinly traded ones can deviate noticeably.
• Bid-ask spread. There is a gap between the highest price a buyer is offering and the lowest price a seller is asking. On a liquid ETF this gap is tiny. On an illiquid one, you may pay a little more to buy and receive a little less when you sell, which is a hidden cost each time you trade.

For this reason, the trading volume of an ETF matters, not just its expense ratio. Before buying, it is worth looking at how many units change hands on a typical day and how wide the spread usually is. Using limit orders rather than market orders is a common way to avoid paying an unexpectedly bad price on a thinly traded ETF.

Costs: expense ratio and everything around it

Every fund charges an annual expense ratio, deducted from the fund's assets, so it is reflected in the NAV rather than billed to you separately. Passive products — ETFs and index funds — generally charge less than actively managed funds because they are not paying a team to pick stocks.

The expense ratio is not the only cost. With a mutual fund, there may be an exit load if you redeem within a specified period. With an ETF, you pay brokerage (which many brokers now charge little or nothing for on delivery trades), statutory charges on exchange transactions, the bid-ask spread, and demat account charges. For a small, infrequent investor, these trading frictions can outweigh the difference in expense ratios.

One India-specific choice applies to regular mutual funds: direct plans versus regular plans. The same scheme is offered in both. A direct plan is bought straight from the AMC without a distributor and carries a lower expense ratio; a regular plan includes distributor commission in its expenses. Over long periods, that difference compounds into a meaningful gap in returns.

Tracking error and tracking difference

Index funds and ETFs aim to match their index, but they never match it exactly. The fund holds some cash, pays expenses, and has to buy and sell shares when the index changes or when money flows in and out. The gap between the fund's return and the index's return is called the tracking difference, and how much that gap fluctuates is called tracking error. AMCs disclose these figures. Two funds tracking the same index with similar expense ratios can still deliver noticeably different results if one tracks its index more tightly than the other.

Investing regularly: SIPs

Systematic investment plans (SIPs), where a fixed amount is invested every month, are built into how mutual funds work in India. You set an amount and a date, and units are allotted automatically at that day's NAV, including fractional units. Many brokers now offer a similar recurring-purchase feature for ETFs, but because ETFs trade in whole units on the exchange, a fixed rupee amount will not always buy an exact number of units, and the purchase happens at the market price at that time.

Taxation

In some countries, ETFs have a structural tax advantage over mutual funds. In India, tax treatment generally depends on what the scheme invests in — for example, whether it qualifies as an equity-oriented fund — rather than on whether it is listed. Tax rules for capital gains on funds have changed several times in recent years, so check the current rules with the Income Tax Department or a qualified tax professional rather than relying on older articles.

Side by side

• Where you buy: mutual funds from the AMC or a platform; ETFs on a stock exchange via a broker.
• Account needed: mutual funds need no demat account; ETFs do.
• Price: mutual funds at end-of-day NAV; ETFs at the live market price, which can differ from NAV.
• Trading cost: mutual funds have possible exit loads; ETFs have brokerage, exchange charges, and the bid-ask spread.
• Automatic monthly investing: built into mutual funds; available for ETFs on some platforms, in whole units.
• Liquidity risk: mutual funds are redeemed by the AMC; ETFs depend on there being buyers on the exchange, though market makers support many ETFs.

Choosing between them

Neither structure is better in general. An index fund can suit someone who wants automatic monthly investing, does not have or want a demat account, and prefers not to think about spreads. An ETF can suit someone who already has a demat account, wants to buy or sell during market hours, and is investing in a fund with good trading volume. In both cases, the things that matter most over decades are the same: what the fund holds, what it costs in total, and how closely it does what it says it does.