A reader in Pune asked us a simple question last month: she wants to put ₹10,000 a month into the Nifty 50, and her colleague says an ETF is cheaper while her bank says an index fund is easier. Who is right? Both, in a way. The ETF vs index fund choice is less about returns, which should be close if both track the same index, and more about how you buy, what you pay along the way and how much effort you want to put in.
This guide explains how each product works, what tracking error means, the costs you see and the ones you do not, liquidity and iNAV, SIP options and how gains are taxed. We do not name any fund. The aim is to help you decide which wrapper suits you, using SEBI’s rules for passive funds and the income tax rules as they stand.
How an index fund works
An index fund is a mutual fund scheme that buys the stocks or bonds in an index, in the same proportions, and tries to mirror its returns. You buy and sell units directly with the fund house, or through a distributor or platform, at the day’s net asset value (NAV). There is no stock exchange involved, so you do not need a demat account or a trading account.
Because the fund house issues fresh units when you invest and cancels units when you redeem, liquidity is rarely a worry. You can redeem any amount on any business day and the money arrives in your bank account after the usual settlement period. You also get the familiar mutual fund conveniences: SIPs, systematic withdrawal plans and switches between schemes of the same fund house.
How an ETF works
An exchange-traded fund, or ETF, holds the same kind of basket, but its units are listed on a stock exchange. You buy and sell them through a broker during market hours, at whatever price buyers and sellers agree on at that moment, just like a share. To do that you need a demat account and a trading account.
The price you trade at is not the NAV. It is a market price that should stay close to the value of the underlying basket, and SEBI has rules to help keep it close. AMCs must appoint at least two market makers for each ETF. Market makers must give two-way quotes, a price to buy and a price to sell, for at least 75% of market hours, and stand behind those quotes.
Ordinary investors cannot usually go back to the fund house to redeem. When SEBI issued its passive funds circular in May 2022, it said direct subscription or redemption with the AMC would be allowed only for orders above ₹25 crore, apart from market makers, and that this threshold would be reviewed from time to time. There is one safety valve: you can redeem directly with the AMC, without exit load, if the ETF trades at more than a 1% discount to NAV for seven trading days in a row, has no quotes for three trading days, or has very thin bids. Otherwise, the exchange is the door in and out.
ETF vs index fund: the main differences
| Feature | Index fund | ETF |
|---|---|---|
| Where you buy | From the fund house or a platform | On a stock exchange, through a broker |
| Price | End-of-day NAV | Live market price during trading hours |
| Accounts needed | Bank account and KYC | Demat and trading accounts as well |
| SIP | Built in | Depends on your broker’s tools |
| Extra costs | Usually none beyond the expense ratio | Brokerage, bid-ask spread, demat charges |
| Liquidity risk | Low, the AMC redeems units | Depends on trading volume and market makers |
Tracking error and tracking difference
No passive fund matches its index perfectly. Cash waiting to be invested, expenses and the cost of buying and selling all pull returns slightly away. SEBI uses two measures to show this, and both are worth checking before you invest.
Tracking error is the annualised standard deviation of the difference between the daily returns of the index and the fund’s NAV, based on the past one year. In plain words, it shows how jumpy the gap is from day to day. For equity ETFs and index funds, SEBI caps it at 2%, except in force majeure situations beyond the AMC’s control, which must be reported to trustees. Every ETF and index fund must publish its tracking error daily on its own website and on AMFI’s.
Tracking difference is the annualised difference in returns between the index and the fund. This is the number that tells you how much return you actually gave up. It must be disclosed monthly for one, three, five and ten years and since launch. For debt ETFs and index funds, the average annualised tracking difference over a year must not exceed 1.25%.
As an illustration, say an index returns 12% in a year. One fund returns 11.8% and another 11.4%. The tracking difference is 0.2 and 0.6 percentage points. On ₹5 lakh, that gap is roughly ₹1,000 against ₹3,000 for the year, and it compounds over a decade.
Costs: the expense ratio is only part of the bill
Both products charge an annual expense ratio, taken out of the NAV daily. Compare the direct plan of an index fund with the ETF on the same index, because regular plans include distributor commission. The fund house’s website and scheme documents list the current expense ratio.
With an ETF, add the costs of getting in and out:
- Brokerage on each buy and sell order, which varies by broker.
- Bid-ask spread, the gap between the best buying and selling price. In a thinly traded ETF this can cost more than a year’s expense ratio.
- Premium or discount to value, when the market price drifts above or below the basket’s worth.
- Demat charges, such as annual maintenance and debit charges when you sell.
- Statutory charges and taxes that apply to exchange trades.
For an investor putting in a large lump sum and holding for years, a low-cost ETF can work out cheaper. For someone investing small amounts every month, per-order costs and spreads can wipe out the expense ratio advantage, which is why many people choose index funds for SIPs.
Liquidity and iNAV: buying an ETF at a fair price
Liquidity is the ETF’s weak point. Popular ETFs on large indices trade heavily, but some niche ETFs see few trades. In those, you may have to accept a poor price to buy or sell quickly. Look at average daily volumes and the spread on your broker’s screen before you buy.
Your best guide is the indicative NAV, or iNAV. SEBI requires every ETF’s iNAV, the per-unit value of its portfolio at current market prices, to be shown continuously on the exchange during trading hours. For equity ETFs it must be updated with a lag of no more than 15 seconds from the underlying market, and for debt ETFs at least four times a day.
A few habits help. Compare the live price with the iNAV before placing an order. Use a limit order rather than a market order, so you set the highest price you will pay. Avoid the first and last few minutes of the trading day, when spreads can be wider.
SIP options in an ETF vs index fund
An index fund makes SIPs easy. You register a mandate once and a fixed rupee amount is invested on a set date every month, buying fractional units at that day’s NAV. You can increase, pause or stop it with the fund house. Use our SIP calculator to see how a monthly amount could grow at a return you assume.
ETFs are bought in whole units, so a fixed rupee amount does not fit neatly. Some brokers offer recurring orders that buy a set number of units or as many units as an amount allows on a chosen day. Check whether your broker charges brokerage on each instalment, because that changes the cost picture. If you prefer one large investment, try the lumpsum calculator instead.
How ETFs and index funds are taxed
The tax rules look at what the fund holds, not whether it is an ETF or an index fund. An equity ETF and an equity index fund that track the same index are taxed the same way. The rates below were set by the July 2024 changes, as explained in the CBDT’s FAQs, and have been carried into the Income-tax Act, 2025, which applies from tax year 2026-27.
| Type of fund | Held 12 months or less | Held more than 12 months |
|---|---|---|
| Equity-oriented (for example, a Nifty or Sensex tracker) | 20% | 12.5% on gains above ₹1.25 lakh a year |
| Debt fund investing more than 65% in debt and money market instruments | Your slab rate | Your slab rate, whatever the holding period |
The slab-rate rule for debt funds applies to units bought on or after 1 April 2023. Gold, international and other funds that fall outside these two groups follow different holding periods and rates, so check the scheme’s tax note before you invest. Any income distributed to you is added to your income and taxed at your slab rate, and fund houses deduct TDS at 10% on such income for residents once it exceeds ₹10,000 in a financial year.
As an illustration, say you invested ₹4 lakh in an equity index fund and sell after three years for ₹6 lakh. Your gain is ₹2 lakh. If you have no other equity gains that year, the first ₹1.25 lakh is exempt and 12.5% applies to ₹75,000, which is ₹9,375 plus cess. The same sum in an equity ETF on the same index would be taxed the same way. Our income tax calculator helps you see your overall tax.
Who each suits
An index fund tends to suit you if:
- You want to invest a fixed amount every month through a SIP.
- You do not have, or do not want, a demat and trading account.
- You prefer not to watch prices or place orders during market hours.
An ETF tends to suit you if:
- You already have a demat account and are comfortable placing limit orders.
- You invest larger, occasional sums where brokerage is a small share of the amount.
- You want to buy or sell at a live price during the day.
- The ETF you want trades actively with tight spreads.
Whichever you pick, the bigger decision is the index itself and how long you will stay invested. A low-cost tracker of a broad index, held for many years, does most of the work.
Key takeaways
- In the ETF vs index fund decision, both track an index; the difference is how you buy, sell and pay.
- Index funds trade at NAV with the fund house; ETFs trade on the exchange at a live price.
- Check tracking difference, not just the expense ratio.
- For ETFs, compare the price with iNAV and use limit orders.
- Equity trackers: 20% tax if sold within 12 months, 12.5% above ₹1.25 lakh after that.
This guide is general information, not a recommendation to buy or sell any fund. Read the scheme documents and consider your own goals before investing.
