Index fund vs ETF

Both products track an index. The mechanism by which an exchange-traded fund keeps its price near its portfolio value, meaning the creation and redemption baskets, the authorised participants and the arbitrage band that closes a discount, belongs to the index and implementation material in the asset-allocation branch and is not rebuilt here. What belongs here is the decision a retail buyer faces, which turns on four things.

The first is the indicative net asset value. An exchange-traded fund publishes a continuously updated estimate of what its underlying basket is worth right now, computed by the fund house or the exchange during trading hours. The traded price can and does differ from it. A fund quoted at ₹248.30 against an indicative value of ₹244.10 is trading at a 1.7206% premium, and on a ₹5,00,000 order that premium costs ₹8,458 before any other cost. Check the indicative value before placing the order. If the premium is wide, refuse it, and never pay it in a hurry.

Tracking difference vs tracking error

Tracking difference and tracking error come second, and they are different objects. The confusion between them is one of the most common errors in retail commentary. Tracking difference is the realised gap between the fund's return and the index's return over a period. It is a signed level, and you can read it directly as money. Tracking error is the standard deviation of that gap. It measures how consistently the fund misses and says nothing about which direction. Over five years, a fund whose annual tracking differences were −0.34, −0.41, −0.29, −0.55 and −0.38 percentage points has a mean tracking difference of −0.394 points and a standard deviation of 0.0878 points. The cumulative five-year shortfall is 1.955%, which on a ₹10,00,000 holding is ₹19,545.

Read those two numbers together. The tracking error of 0.09 points says this fund is extremely consistent. The tracking difference of −0.394 points says it consistently loses to its index by about four times its stated expense ratio, and that consistency makes the loss reliable. It should not reassure you. A fund with a small tracking error and a large tracking difference is a well-run fund that is expensive. A fund with a small tracking difference and a large tracking error is a cheap fund with an operational problem. You need both numbers.

Does the ETF arbitrage still work?

The third is a condition with no number attached. Does the arbitrage still work? The mechanism that keeps price near value depends on somebody being able to trade the underlying basket cheaply and immediately. It weakens when the underlying market is closed, when the underlying is illiquid, when there is a single authorised participant, and when regulatory limits stop new units being created. Indian holders have seen this in international funds, where inflow limits have at times forced schemes to stop accepting money and their exchange-traded versions to trade at large premiums [verify: the schemes' own addenda and the applicable overseas-investment limits, checked with the fund house]. A premium that persists for weeks is a sign the arbitrage is switched off. Paying it means paying for a number that will not survive the mechanism being switched back on.

Index fund vs ETF: total cost of ownership

Total cost of ownership is the fourth, and it settles the decision. The exchange-traded fund usually has the lower expense ratio. The index fund usually has zero trading cost and no premium risk. The crossover depends on how often you trade and how much you hold. For a monthly investment plan of a modest size, the index fund almost always wins, because twelve trades a year each carrying brokerage and a spread will beat any plausible expense-ratio saving. For a single large lump held for years, the exchange-traded fund usually wins. Compute the crossover with the holding period and the order count as inputs. Asserting it is not enough.