Index Fund vs ETF in India: Tracking Error, Liquidity & the Demat Hassle

The Illusion of Choice

You have read the books. You have watched the financial influencers. You have finally accepted the golden rule of modern wealth creation: Active mutual funds rarely beat the market over 20 years. Passive investing is the ultimate path.

You decide to invest exactly ₹20,000 every month into the top 50 companies in India (The Nifty 50).

You open your brokerage app, search for "Nifty 50", and suddenly, you hit a wall. There are two very different structural vehicles offering you the exact same underlying product: The Index Fund and The ETF (Exchange Traded Fund).

• •Both buy exactly the same 50 stocks in the exact same weightage.
• •Both are incredibly cheap compared to active funds.
• •Both are mathematically guaranteed to mirror the Indian market.

Yet, on Reddit forums and FinTwit, brutal internet wars are fought daily over which one is "superior." ETF maximalists scream about expense ratios and intraday control. Index Fund loyalists preach about absolute simplicity and automated peace of mind.

This is the definitive 2026 guide to the hidden mechanics of passive investing in India. We will dissect the Demat requirement, the liquidity bloodbaths, the Tracking Error truths, and settle the debate once and for all.

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Part 1: The Core Structural Difference

To understand the difference, you must understand how the "grocery store" of finance works.

The Index Fund: Ordering Directly from the Factory

When you invest ₹10,000 in a UTI Nifty 50 Index Fund, you are dealing directly with the Asset Management Company (AMC). You send them cash. At the end of the day, when the market closes at 3:30 PM, they calculate the exact value of all their stocks. This is the NAV (Net Asset Value). They issue you new, fresh mutual fund units corresponding precisely to your ₹10,000 at that exact end-of-day NAV.

The ETF: Haggling in the Open Bazaar

An ETF is a mutual fund that has been listed on the National Stock Exchange (NSE). When you want to buy ₹10,000 worth of Nippon India Nifty 50 BeES (an ETF), you do not interact with the AMC. You log into your trading terminal and you buy those units from another human being or institution who is selling them live on the exchange.

The price flashes green and red every second from 9:15 AM to 3:30 PM. You are directly participating in the brutal real-time supply and demand mechanics of the stock market.

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Part 2: The Demat Toll Booth

Before we talk about returns, we must talk about infrastructure.

Index Funds:

• •Requirement: Zero. You do not need a Demat account or a trading account.
• •Access: You can buy them directly on AMC websites, or through minimalist apps like Kuvera, Groww, or MFUtility.
• •Cost of Infrastructure: Free.

ETFs:

• •Requirement: Absolute strict requirement. You must have an active Demat and Trading account with a broker (Zerodha, Upstox, ICICI Direct).
• •Cost of Infrastructure: You pay Annual Maintenance Charges (AMC) to the broker (₹300 - ₹1000/year). You pay Depository Participant (DP) charges every time you sell the ETF. You pay brokerage (even if it's minimal equity delivery).

The Verdict on Infrastructure: If you are strictly a mutual fund investor and do not intend to buy individual stocks (Reliance, HDFC), opening and maintaining a complex Demat account purely to buy ETFs is an unnecessary bureaucratic headache and a recurring annual cost that erodes your returns.

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Part 3: The Expense Ratio vs The Hidden Costs

This is where the ETF maximalists usually win the argument on paper.

If you look at the raw data:

• •A direct Nifty 50 Index Fund has an Expense Ratio around 0.20%.
• •A Nifty 50 ETF has a dirt-cheap Expense Ratio of around 0.05%.

Mathematical perfectionists see that 0.15% difference, compound it over 20 years, and declare the ETF the undisputed champion.

But the Indian stock market is not a spreadsheet. Real-world trading involves friction.

The Hidden Friction of ETFs:

When you buy an Index Fund, ₹10,000 buys you exactly ₹10,000 worth of NAV. When you buy an ETF, your 0.05% expense ratio suddenly balloons due to structural leakages:

1. •The Bid-Ask Spread: You want to buy the ETF at ₹250.00. The lowest seller in the market is asking for ₹250.20. You are forced to pay a premium just to get the trade executed. This instantly vaporizes your 0.15% expense ratio advantage.
2. •Price-NAV Deviation: Because ETFs trade on supply/demand, the live trading price often detaches from the actual underlying NAV of the 50 stocks. During sudden market crashes in India, panicked sellers dump ETFs, causing them to trade at massive discounts to NAV.
3. •Brokerage & DP Charges: Every buy incurs minor STT and exchange charges. Every sell incurs a flat ₹15.93 DP charge from CDSL.

The Verdict on Cost: For SIP amounts under ₹50,000 a month, the hidden frictional costs, DP charges, and spread losses of an ETF completely wipe out the tiny advantage of its lower expense ratio. The Index Fund is practically cheaper in the real world.

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Part 4: The Liquidity Nightmare

Liquidity simply means: "When I am desperate to sell my asset and get my cash, are there enough buyers available?"

Index Funds: Liquidity is essentially infinite and guaranteed. The AMC is legally obligated to buy back your units at the exact end-of-day NAV. Whether you sell ₹10,000 or ₹10 Crores, the AMC handles the liquidity. You never have to find a buyer.

ETFs: Liquidity is the darkest, most dangerous secret of the Indian ETF market. If you are trading highly popular Nifty 50 ETFs (like NiftyBeES), liquidity is excellent. There are millions of buyers and sellers.

But if you stray even slightly off the beaten path—say, a Nifty Midcap 150 ETF, a Pharma ETF, or a Silver ETF—the liquidity completely dries up. You might desperately need your money for a medical emergency. You log in to sell your ₹5 Lakhs worth of Midcap ETF. You look at the market depth screen, and there are literally zero buyers at the fair price. The only buyer available is offering a price 3% below the actual NAV.

You are forced to take a devastating 3% loss simply because the Indian ETF market lacks depth.

(Note: AMCs deploy "Market Makers"—institutional players hired to provide liquidity—but during extreme market panic, even these market makers vanish or widen their spreads brutally).

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Part 5: Tracking Error (The True Test of Replication)

Tracking Error is the ultimate metric of passive investing. If the Nifty 50 went up exactly 15.00% this year, a perfect passive instrument should go up 15.00%. If your fund went up 14.70%, that 0.30% difference is the Tracking Error.

Why does Tracking Error happen?

1. •Fund management fees.
2. •Execution delays when rebalancing the portfolio.
3. •Cash Drag (The Index Fund Killer).

The Index Fund's Weakness: When an Index Fund receives ₹500 Crores in SIPs today, it cannot instantaneously deploy all 100% of that cash into the 50 stocks. Furthermore, it must keep 2-5% of its total corpus in pure cash sitting idle in a bank account just to handle daily redemption requests from investors leaving the fund. Because 5% of the fund is in cash, it "drags" behind the fully invested index.

The ETF's Advantage: ETFs do not maintain massive cash reserves for redemptions. If you want to sell, you sell it to another trader in the market; the ETF manager doesn't have to scramble to find cash to pay you. Therefore, ETFs remain 99.9% deployed in equities at all times.

Historically, massive, highly-liquid ETFs in India (like SBI Nifty 50 ETF) have demonstrated lower, tighter Tracking Errors compared to their Index Fund counterparts.

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The Verdict: Which One Should You Pick in 2026?

The ETF vs Index Fund debate is not about which mathematical structure is superior. It is entirely about your behavioral psychology as an investor.

Profile A: The ETF Trader (The 10%)

Choose the ETF ONLY IF you meet these strict criteria:

• •You already possess a very active Demat account where you trade direct equities.
• •You have large lumpsum amounts to deploy (₹5 Lakhs+) and you demand to execute the trade at 11:30 AM during a sudden flash-crash to "buy the dip" instantly.
• •You understand how to execute Limit Orders to protect yourself from bid-ask spreads.
• •You strictly stick to ultra-liquid large-cap ETFs (Nifty 50 or Bank Nifty).

Profile B: The Index Fund Investor (The 90%)

Choose the Index Fund if you want to build wealth with absolute, automated tranquility.

• •The Power of SIP: Index funds allow you to set up a true "set-it-and-forget-it" bank mandate. On the 5th of every month, direct cash is debited and deployed without any human emotion, no logging into a broker, no staring at red/green flashing tickers.
• •Fractional Units: An Index Fund allows you to invest exactly ₹2,000. An ETF requires you to buy whole units based on the live price (which leaves annoying amounts of uninvested cash in your trading ledger).
• •Zero Liquidity Anxiety: When you retire 20 years from now and need to run a Systematic Withdrawal Plan (SWP) of ₹1 Lakh a month, the Index Fund systematically handles the math. An ETF SWP is a logistical and execution nightmare.

The Final Word: For the modern Indian retail investor looking to build a ₹5 Crore core portfolio through decades of compounding, The Index Fund is the undisputed king.

The 0.10% you lose on the expense ratio is the premium you pay for absolute psychological peace, guaranteed liquidity, and the removal of the toxic urge to "time the market" that comes with a live trading screen.

Set up your Index Fund SIP. Delete the app. Go live your life.