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

Published: March 22, 2019 at 9:57 am

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.

ETFs vs Index Funds: Stop assuming lower expenses equals higher return

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,

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

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 Sensex ETF vs Tata Index fund rolling returnsSBI Nifty Index fund Vs ICICI Nifty ETF 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?

Latest from freefincal on YouTube


Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)