What is the difference between an index fund and an ETF?

Both are schemes that aim to replicate an index. An index fund is bought and sold with the asset manager at the end-of-day net asset value. An ETF is listed on an exchange and traded intraday through a broker at whatever price the market offers, which can sit slightly above or below the underlying value.

Do ETFs always cost less than index funds?

Not necessarily in total. ETFs often carry a lower expense ratio, but you also pay brokerage, exchange charges and the bid-ask spread on every trade, and you may transact at a premium or discount to underlying value. The right comparison is total cost of ownership over your actual holding pattern, not the headline ratio alone.

What is tracking difference and why does it matter more than the expense ratio?

Tracking difference is the gap between what the fund actually delivered and what the index delivered over the same period. It captures fees plus trading costs, cash drag, replication method and dividend handling all at once. It is the outcome you experience, whereas the expense ratio is only one input to it.

Index Funds vs ETFs in India: Structure, Tracking and Costs

An index fund and an exchange-traded fund can follow exactly the same index and still behave differently for the investor, because the difference between them is not the portfolio but the wrapper. An index fund is a conventional open-ended scheme: you transact with the asset manager at the end-of-day net asset value. An ETF is a listed scheme: you transact with other market participants on an exchange, at whatever price is available at that moment.

Everything that follows, meaning who you trade with, what price you get, what you pay to trade, and where the tracking gap comes from, is a consequence of that single structural difference.

The two structures

Index fund. A standard mutual fund scheme whose objective is to replicate a stated index. Subscriptions and redemptions happen with the asset management company at the applicable NAV, computed once at the end of the day using the cut-off rules. You do not need a demat account or a broker. Systematic investment plans and systematic withdrawal plans are straightforward, because the AMC processes instructions directly. An exit load may apply within a defined period, depending on the scheme.

Exchange-traded fund. A scheme whose units are listed and traded on a stock exchange like a share. You need a demat account and a broker. Units trade throughout market hours at a market price set by supply and demand, which is anchored to but not identical to the underlying value of the basket. Very large investors, typically institutions acting as authorised participants, can create or redeem units directly with the AMC in large lot sizes, exchanging the underlying basket for units or the reverse. That creation and redemption mechanism is what keeps the market price close to the underlying value: when the price drifts too far, the arbitrage becomes worth executing.

There is a third structure worth knowing about. Some index-tracking schemes are funds of funds that hold an underlying ETF rather than the securities themselves. That adds a layer, so the total cost is the fund-of-fund expense plus the underlying ETF’s expense, and the tracking gap accumulates across both layers.

Side by side

Axis	Index fund	ETF
Where you transact	With the AMC	On the exchange, with other participants
Price you get	End-of-day NAV	Market price at the time of trade
Account needed	Folio with the AMC	Demat and broker
Intraday trading	No	Yes
Transaction costs	Usually none beyond the scheme, plus any exit load	Brokerage, exchange charges, applicable taxes, bid-ask spread
Premium or discount risk	None, you get NAV	Yes, price can deviate from underlying value
SIP mechanics	Native and simple	Depends on broker support, executed as market orders
Typical expense ratio	Usually higher than the equivalent ETF	Usually lower
Liquidity depends on	The AMC’s redemption process	On-screen volume plus market maker activity plus the creation mechanism

Tracking difference, and why it is the number that matters

For a passive product, the honest performance question is not “what return did it make” but “how far did it land from the index it promised to follow”. Two related measures answer that.

Tracking difference is the gap between the fund’s return and the index’s return over a period. It is a level: the fund returned this much less, or occasionally more, than the index. It is the outcome you actually experience.

Tracking error is the volatility of that gap over time. It measures consistency of replication rather than its level. A fund can have a steady, predictable shortfall, which is low tracking error with a meaningful tracking difference, or an erratic gap that sometimes helps and sometimes hurts.

Tracking difference comes from several sources, and the expense ratio is only one of them:

Fees. Charged daily against NAV, so they show up as a persistent drag. See expense ratio impact on returns.
Trading costs of replication. Every index review forces the fund to buy incoming constituents and sell outgoing ones, paying spread, impact and taxes. Broader indices with more small constituents cost more to replicate than narrow, liquid ones. See index rebalancing explained.
Cash drag. Cash held for flows and for dividend timing earns less than the index in rising markets.
Dividend handling. The index assumes dividends are reinvested instantly at the ex-date. A real fund receives cash later and reinvests it later. That timing gap is a genuine, structural source of shortfall, and it is why the comparison must be against a total return index rather than a price index, as explained in total return index vs price index.
Replication method. Full replication holds every constituent at index weight. Sampling holds a representative subset, which is cheaper for indices with a long illiquid tail but introduces an extra source of deviation.
Securities lending, where permitted, can offset some costs and slightly reduce the gap, while introducing its own considerations.

For an ETF, the investor experiences one more layer on top: the price you paid versus the underlying value at that moment. A fund can track its index beautifully while you personally buy at a premium and sell at a discount.

The ETF-specific issues to check

Spread and depth. A thinly traded ETF can show a wide gap between the best buy and sell prices, and that spread is a real cost paid on entry and again on exit. It can easily exceed a year of the expense ratio difference for someone who trades often.

Premium and discount. The market price is kept near the underlying value by arbitrage, but that arbitrage is only worth doing when the gap is large enough to cover the arbitrageur’s costs. In volatile sessions, or in ETFs holding assets whose own markets are closed or illiquid, gaps can widen. Comparing the traded price to the published indicative value before placing an order is basic hygiene.

Order type. Because you are trading in a live market, a market order in a thin ETF can execute far from where you expected. This is the same mechanism described in slippage and impact cost, applied to your own purchase.

Corporate action and index events. ETFs and index funds both have to handle constituent changes, and the mechanics of adjusted prices matter for anyone measuring historical tracking, as covered in corporate actions and adjusted prices.

Taxation, structurally

Rates and holding periods change with legislation, so treat what follows as structure rather than current law, and check the applicable rules. Structurally, the tax treatment of a scheme in India depends on what it holds rather than on whether it is listed. Equity-oriented schemes, whether structured as an index fund or an ETF, fall under the equity treatment, while schemes holding debt, gold or overseas assets follow their own respective treatments. The taxable event in both wrappers is your sale or redemption of units, and the holding period runs on the units you hold. Internal rebalancing inside the scheme is not a taxable event for you in either structure. The concepts are laid out in short-term vs long-term capital gains in India.

What this comparison does not tell you

Neither wrapper is better in general. The right one depends on how you transact, how often, in what size, and whether you need intraday execution or systematic contributions. Nothing here recommends either.
The headline expense ratio is not the answer. Total cost of ownership includes spread, brokerage and the price you actually transacted at. A lower ratio can be entirely erased by a wide spread for someone making frequent small purchases.
Past tracking difference does not guarantee future tracking difference. Replication quality can change with fund size, flows, index composition and market conditions.
The index choice matters more than the wrapper. Both structures deliver whatever their index delivers, minus costs. Choosing the index is the substantive decision, and index construction is covered in how Indian indices are constructed and Nifty 50 vs Nifty 500.
Passive does not mean risk-free. An index-tracking product carries the full market risk of its index, including its concentration in the largest constituents.
It says nothing about specific schemes. Costs, spreads, replication quality and liquidity vary enormously between individual products within each structure.

The practical framing is simple. Decide the index first. Then choose the wrapper that matches how you will actually transact. Then judge the specific product on realised tracking difference and, for an ETF, on the spread you will pay to get in and out.

Portfolio metrics explained: the hub for how fund and portfolio performance is measured.
Expense ratio impact on returns: the compounding effect of the fee layer.
Why active funds underperform benchmarks: why the passive comparison is a demanding bar.
Total return index vs price index: the index series a tracking comparison must use.
PMS vs mutual funds vs stock baskets: how these wrappers sit against the other vehicles available.

This article is educational. Altys Labs is not a registered research analyst or investment adviser, and nothing here is investment advice or a recommendation to buy, sell, or hold any security.