Index funds and ETFs are passive investment instruments. Both invest in stocks in the same proportion as their underlying market indices and thus mirror the risk and return of the indices. Index funds are very similar to open-ended mutual funds, where the fund manager invests in securities and replicates the underlying indices without security selection. As one makes investments and redemptions in these index funds, the fund manager manages cash for the investor and thus these funds will have a small tracking error in their performance.
ETFs on the other hand, have funds already invested in the same proportion as the underlying indices and then their units are traded on exchanges. When someone buys the units, there is a counterparty selling them. The ETF manager does not need to manage any kind of withdrawal from investors which leads to a smaller tracking error compared to index funds. However, one can buy or sell only if counter parties are available, and therefore the market must have enough liquidity to buy or sell ETF units. Typically, the liquidity is very low for high value investments. Ex: Highest trading ETF has an average traded value of ~Rs 21.3 crore with next in-line being at ~Rs 2.7 crore. Thereafter, all are relatively small as of now.
When one invests in an index fund, the price for purchase or redemption of units will be the net asset value (NAV) declared by the AMC at the end of the trading day. The price of ETFs, akin to listed equity shares, are determined through price discovery because of supply-demand and liquidity in the market and may thus be trading at a premium or discount to the actual NAV. So, in times of heightened volatility, one could see a significant spread in the ETF price and index level. Usually those who are investing for hedging or trading may find that an ETF is a better option. However, for a long-term investor, this is not a deciding factor.
Index funds usually have a lower expense ratio compared to active funds because of lower portfolio construction and management costs. ETFs have even fewer expenses compared to index funds but while purchasing or selling units one incurs other charges such as brokerage, demat charges and associated taxes. These charges should be taken into consideration while looking at the returns of index funds and ETFs.
Investors do not require a demat account to invest in index funds, as the purchase and redemption of units is done directly with the AMC. However, a demat account is a must for investing in ETFs, thereby increasing the costs incurred due to charges like demat opening charges and annual maintenance charges.
Index fund redemptions prior to a specified duration of time maybe subject to an exit load by the AMC, whereas investors may sell ETF units at any point of time post their purchase, without incurring any exit load.
Taxation wise both are similar and will be subject to STCG or LTCG on the basis of the holding period.