ETF vs Index Fund: 6 Hidden Traps Costing You Returns

Exchange Traded Funds (ETFs) and Index Funds are promoted as products that are cheap, passive and friendly to the investor. To the majority of the beginners and even seasoned investors, the evaluation between the two, i.e., the ETF and Index Fund, appears to be a mere face-off on the surface as the two both track an index, both should offer returns comparable to the market, and both are deemed to be the best to invest in the long-term.

And this is the awkward reality. It is the ignorance of traps within ETFs and Index Funds that drives many investors to lose returns not due to market declines but due to their ignorance.

Today, we are going to reveal the 6 traps lurking in your pocket to rob you of money, unless you know how ETFs actually work in comparison with index funds. It is important to note that ETFs and Index funds differ in several aspects, very briefly. We will make a cursory establishment before plunging into the traps.

What Is an ETF?

An ETF is an investment fund that follows an index but it trades in the stock exchange like a share does. You sell it and buy it in the market at market prices.

What Is an Index Fund?

An index fund is a mutual fund that tracks an index; however, it is bought or sold at NAV (Net Asset Value) straight at the fund house. On paper, both look identical. In practice, they act in a much different way.

Trap One ETF Bid-Ask Spread: The Silent Return Killer.

The bid-ask spread of an ETF is one of the least-known ETF hidden costs.

What Is Bid-Ask Spread?

Bid price: Price that buyers are ready to pay. 

Ask price: Price sellers are asking for.

The difference between the two is the spread which is an actual cost paid by the investor.

Why This Matters

ETFs are highly liquid, which means that they are narrow-spread.

Low-volume ETFs → wide spreads

A wide spread means:

• You buy at a higher price.
• You sell at a lower price.
• Your returns drop instantly.

The repeated selling and buying increase this loss over the years.

Note:  Index funds are free of bid-ask spreads. You always transact at NAV.

ETF Tracking Error Trap: It Can Be Much Greater Than You Think

Tracking error indicators refer to the degree to which a fund tracks its indices.

A Common Myth is that ETFs always keep up with the index while reality is that ETFs may be afflicted by increased ETF tracking error because of:

• Cash drag.
• Rebalancing delays.
• Illiquid underlying stocks.
• Market impact costs.

Example

If the index returns 12%:

ETF returns 11.2%

Tracking error = 0.8%

It is only 0.8 %, but after 2030 , it will grow into a huge wealth chasm.

In long-term portfolios, index funds are likely to exhibit more consistent tracking, particularly large index funds. Liquidity Illusion in ETFs is trap number three. Not every ETF is liquid - despite the popularity of the index.

Hidden ETF Trap

Many ETFs show low daily trading volume, low number of active participants in the market which creates difficulty in purchasing/selling huge amounts, a higher price impact, abrupt NAV match market price.

Who Suffers the Most?

• SIP investors
• Retail investors who may have invested on the volatile days.
• Long term investors leaving in market distress.

The same problem does not happen to index funds since the fund house has addressed the issue of liquidity, rather than the stock market.

Expense Ratio Is not the Complete Story

ETFs are marketed as being less expensive as indicated by low expense ratios. But cost value is not just a factor of expense.

Hidden ETF Costs Include:

• Brokerage charges
• The rate of this is called the STT (Securities Transaction Tax).
• Exchange fees
• Demat maintenance
• Impact cost due to spreads.

When you add everything, ETFs can even be more costly to the investor in the long-term than index funds.

Index Fund Advantage

• No brokerage
• No bid-ask spread
• Single transaction using NAV.

This is the reason why the index fund long-term investors will tend to have a smoother compounding.

Emotional trading kills the returns of ETFs.

Since ETFs are traded in the stock market, it would mean that investors are more likely to act as traders and not as long-term investors.

Implementing the following behavioral errors is common in ETFs.

• Buying on intraday highs
• Selling in corrections as panic.
• Overselling because of the visible price.

This behavioral discrepancy silently costs returns - even in an otherwise well-performing ETF.

Index funds cushion an investor against himself:

• No intraday trading
• NAV is calculated once per day
• Promotes strict SIP investment.

Researchers continue to find that it is not product choice, but investor behavior that is the largest destroyer of returns.

Index Construction Risk

• There are thematic or narrow index funds represented by some ETFs.
• Churn is enhanced by the high rate of change of indices.
• Rebalancing expenses are indirectly transferred to investors.

When the index under it is volatile, the ETF increases the issue. Index funds are commonly favored with respect to:

• Stable index methodology
• Lower turnover
• Greater foreseeability in the long-term objectives.
  
  

ETF vs Index Fund: Which is better than the other?

ETFs Are Better If:

• You have been an aged investor.
• You are familiar with bid-ask spreads.
• You do not deal frequently, but accurately.
• You invest in ETFs which are very liquid.

Index Funds Are Better If:

• You are a long-term investor
• You invest via SIPs
• You like things simple and straight.
• You do not desire secret execution prices.

To the majority of retail investors, who are interested in the long-term wealth creation of index funds, simplicity is better than sophistication.

Ending Judgment: Be Aware of the Traps Before You Fall.

The ETF vs Index Fund debate is not on which is better in all cases. It is about the secrets of being prepared to the traps and matching the product with your actions and objectives.

 

 

Key Takeaways

ETFs contain opaque fees besides cost ratios. Tracking error and ETF bid ask spread are important to most investors than they might think. Index funds minimise emotional risk, execution risk. Long-term wealth is achieved not through complexity but through discipline or Spreads, liquidity, timing, etc. - you cannot actively track them, and this is how ETFs can silently beat index funds over decades.

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.