ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!

Last Updated on December 29, 2021 at 11:51 am

So many people make the mistake of assuming that just because an ETF has a lower expense ratio than an index fund, it will result in higher returns (excluding demat account fee and brokerage), There is no evidence to this. The return from an index fund or an ETF depends on several factors. In this post, we will see how an index fund with a significantly higher return than an ETF can result in comparable or even a bit more return.

In the case of an index fund, how closely it tracks the index is measured by the tracking error. Although this is not an intuitive number, too many people use it forgetting that sometimes index funds can outperform their indices for the wrong reasons! So it is important to always use returns to track performance.

In this case of an ETF, the return that one gets is decided by the price of the unit and not the NAV of the unit. If you are new to ETFs and how they work, please start with this post: How ETFs are different from Mutual Funds: A Beginner’s Guide and then Interested in ETFs? Here is how you can select ETFs by checking how easy it is to buy/sell them,

Only when the difference between the ETF price and ETF NAV is not too much, see for example how to check this here: What is the best way to invest in Nifty Next 50 Index – can one use the NAV as a proxy for the price. Unfortunately, all portals use ETF NAV for computing tracking error and returns. The ETF tracking error is not representative of how much investor returns differ from index returns.  For this article, I use some graphs previously used to compare a NIfty Next 50 ETF and an index fund.

ICICI Prudential Nifty Next 50 Index Fund-Direct Plan vs  Reliance ETF Junior BeES

Earlier I was under the impression that the NAV reported does not include ETF dividends (they declare these and it can either be put back into the fund or distributed). However, thankfully, this is not the case, The dividends (if any) seem to treated as reinvested for NAV computation.

Three years: Index fund NAV vs ETF NAV

First, let us compare the 3 year rolling return and rolling risk of ETF and index fund. We shall use the ETF NAV.

Three years: Index fund NAV vs ETF Price

When we use the ETF price instead of the NAV (the right thing to do), the outperformance is not as high.

The risk (shown in the bottom panel) is also higher for the ETF price due to market forces. However, notice that even though the ETF has significantly lower expense ratio than the index fund (about 0.5% at the time of writing), this does not result in return or risk outperformance.

The trend is the same for four and five years. Check out the video below or this post: What is the best way to invest in Nifty Next 50 Index?

SBI Sensex ETF vs Tata Index fund 3 year rolling returns

SBI Nifty Index fund Vs ICICI Nifty ETF rolling returns

For both of the above cases, notice that sometimes the ETF does better (NAV was here) and sometimes the index fund. So outperformance does not depend on expense alone. So please stop assuming lower expenses will result in higher returns!

Video Version

Summary: What should be done?

I would suggest the following:

1. Stay away from ETFs where the price to nav difference is frequently high. See List of Index Mutual Funds and ETFs in India: What to choose and what to avoid
2. Always compare returns of the index fund with the index fund and the same with the ETF. Do not use a tracking error.
3. Do not forget to factor in brokerage and demat fee when you are comparing index funds with ETFs.
4. There is only one situation where lower expense will result in higher returns. That is with direct funds as the portfolio is identical to that of the regular fund: Which are the most popular direct plan mutual funds?

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