ETFs or index funds: Where should smart money really go?

Investment

• ETFs and index funds provide low-cost, passive investing by tracking market indices.
• ETFs need a demat account and may have liquidity risks from low trading volumes.
• Index funds are easier to trade, with lower tracking error and no fund manager risk.

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Passive investing has steadily gained traction among investors seeking low-cost, market-linked returns without the risks associated with stock picking.

Products such as exchange-traded funds (ETFs) and index funds are designed for this purpose, as they aim to replicate the performance of a market index rather than outperform it.

This shift is clearly reflected in investor behaviour. A study by Motilal Oswal Asset Management Company in October 2025 shows that 68 percent of investors had invested in at least one passive fund in 2025, up from 61 percent in 2023. The study also notes that passive fund assets under management (AUM) stood at Rs 12.2 trillion, a 6.4-fold rise over six years- from Rs 1.91 trillion in 2019- translating into a compound annual growth rate (CAGR) of 36 percent.

While both ETFs and index funds track an underlying index, they differ significantly in how they are bought, sold and priced. Understanding these differences, along with costs, liquidity considerations and return expectations, is crucial before choosing between an ETF, an index fund or an actively managed equity fund.

Here’s a simple breakdown of how these products work and which option may best suit your investment style.

Exchange Traded Fund

ETFs are traded on stock exchanges and are designed to replicate the performance of a specific index. For example, a Nifty 50 ETF holds the same stocks as the Nifty 50 index, in the same proportions as their index weights. This allows investors to gain exposure to a chosen segment of the market through a single, exchange-traded investment.

As ETF units are bought and sold only on the exchanges, investors require a demat account and securities trading account to invest in an ETF. The investor has to pay the brokerage while buying and selling the units of the ETF.

An ETF has a relatively lower expense ratio compared to an index fund and a regular mutual fund scheme.

However, the traded volumes of ETF units in the exchanges might be low. Therefore, ETFs are subject to liquidity risk. There is a chance that the units of the ETF may not trade at the net asset value (NAV) due to the paucity of liquidity, which affects price discovery.

Index fund

Index funds function like traditional mutual funds and invest in well-known indices such as the Nifty 50 or Sensex. Unlike ETFs, investing in index funds does not require a demat account. However, index funds typically have higher expense ratios than ETFs, as they involve fund management and operational costs, even though the portfolio simply tracks an index.

A fund manager is mandated to buy all stocks of the index in the same proportion as they are in the index. The manager does not use his discretion while choosing the stocks in portfolio and passively replicates the index. The idea is to generate the same returns as the index before expenses and tracking errors. Tracking error is the difference in the returns of the index fund and the underlying index.

An actively managed diversified equity fund has the potential to outperform the benchmark index if the fund manager gets his calls right. In case the fund manager picks stocks that end up underperforming, the fund lags the index.

Index funds vs. ETFs: Which one to choose?

When choosing between an ETF and an index fund under a passive investing strategy, investors need to focus on a few key factors.

One needs to consider how closely the fund tracks its underlying index is critical, as measured by the tracking error. The lower the tracking error, the closer the ETF’s returns are to the index.

Liquidity is another crucial consideration for ETFs, since higher trading volumes ensure investors can buy or sell at prices close to the market value.

Finally, investors should look at the overall cost of ownership: ETFs are generlly cheaper but involve additional expenses such as demat and brokerage charges, while index funds offer a simpler, bundled cost structure through a single expense ratio. Hence, one needs consider the overall cost of ownership before making a final decision.