ETFs are open ended funds whose units are traded in a stock exchange. Investors buy units directly from the mutual fund only during the NFO of the scheme. All further purchase and sale transactions of the units are conducted on the stock exchange where the units are listed.

ETFs can be bought and sold throughout the day on stock exchanges at the real time traded price while Mutual Funds are bought and sold based on their price at the day's end (NAV end of the day).

Most ETFs hold the same securities in the same proportions as a certain stock market index, like Sensex or Nifty. So, it is like investing in all the stocks in an index. If the index grows 10%, the fund also grows the same percentage. If the index falls 10%, the fund falls the same percentage. There is no active role for a fund manager in this case. Though at certain times such funds do better than actively managed funds, however in a developing market like India, most of the times, actively managed funds perform better because of the fund manager's expertise. If the fund management team is good, actively managed funds are found to be giving better returns than Index funds, especially in the long term.

Expense ratio of an ETF is less than actively managed funds but the brokerage to be paid while buying/selling the ETF through a broker on the exchange comes as an extra cost for the investor.

Demat Account is mandatory for an ETF just like you need Demat Account for investing in Direct Stocks.

ETFs do not allow SIP, STP, SWP etc. This is a disadvantage compared to mutual funds.

ETFs can be bought like a normal stock during trading hours at the real time NAV/Traded Price. But, it is possible that the traded ETF may not have enough volumes being traded in a stock exchange always, and hence the traded price may be different from the live NAV of the fund resulting in additional cost for the investor sometimes.

Index Funds v/s ETFs

While index funds and ETFs look similar, there are multiple differences you need to keep in mind before investing in either of them. Let me highlight the important ones.

(a) NAV – Index funds can be bought/sold like any other open-ended MF at the day end NAV from the AMC whereas ETFs can be bought like a normal stock during trading hours at the real time NAV/Traded Price or iNAV.
(b) Expense Ratio – Theoretically, expense ratio of an ETF is less than Index funds but it does not include the brokerage to be paid while buying/selling the ETF through a broker on the exchange and hence don’t compare expense ratios directly between Index funds and ETFs.
(c) Index fund allows SIP, SWP, STP and ETFs don’t.
(d) Demat is mandatory for ETFs and optional for Index Funds.
(e) Bid-Ask Spread – This is extremely important. It is possible that the traded ETF may not have enough volumes and hence the traded price may be different from the live NAV (iNAV) resulting in additional cost.

How does the AMC make sure the Traded price of an ETF is close to iNAV?

(a) AMC’s appoint market makers; whose job is to create liquidity in the ETF by quoting buying/selling prices on the exchange and there by keeping the Traded price close to iNAV
(b) If a large investor wants 2 buy/sell large quantity (Pre defined, let's say 50 Lakh worth of investment for an example), then the investor can directly reach the AMC and AMC will buy and sell directly at the iNAV and the investor does not need to go through the exchange

What to look for in Index funds before investing?

(a) Index you want to invest in – Sensex, Nifty, S&P 500, Nifty next 50 etc. – depending on the risk/return expectation and diversification requirement of the portfolio
(b) Expense Ratio – Lower the better
(c) Tracking differences and Tracking errors of the funds – Lower the better