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

Published: March 22, 2019 at 9:57 am

Last Updated on

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,

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 if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only 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, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
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 low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, 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 199 (instant download)
Free android apps