ETFs vs. Direct Mutual Funds: The Hidden Costs of 'Cheap' Investing in India
- Abraham Cherian
- Jan 16
- 8 min read
Why This Choice Matters More Than You Think
(image from gripinvest)
When Priya, a 28-year-old software engineer in Bangalore, decided to invest ₹10,000 monthly for retirement, she thought the math was simple. "Lower fees mean better returns," she reasoned, opting for an exchange-traded fund (ETF) with a 0.4% expense ratio over a mutual fund with a 2% total expense ratio.
Ten years later, Priya's ₹12 lakh investment had grown to ₹18.5 lakh in her ETF. Her colleague Rajesh, who invested the same amount in a direct mutual fund plan with 0.5% fees via automatic SIP, had ₹19.2 lakh—not because his fund outperformed, but because he never missed a month, never timed the market wrong, and let compounding work undisturbed.
Both are successful, but for different reasons. The choice between ETFs and mutual funds isn't really about which costs less on paper—it's about understanding which one fits your temperament, time availability, and financial discipline.
The Real Cost of "Cheap": Understanding True Investment Costs
Most investors fixate on expense ratios while missing the complete picture. The image you reviewed shows this brilliantly: a 0.4% ETF might have 10× lower expense ratios than some funds, yet still cost you more than a mutual fund over time.
Here's why the headline number lies:
Cost Component | ETFs | Mutual Funds |
Expense Ratio (passive) | 0.35-0.65% | Index: 0.6-1%; Active: 1.5-2.4% |
Entry Cost | Bid-ask spread: 0.1-5% | Zero (SEBI abolished entry loads in 2009) |
Exit Cost | Nil (no exit load) | 0.5-2% for early redemption |
Hidden Costs | Brokerage charges | Distributor commissions (only in regular mutual funds) |
Direct Plans | N/A | 0.3-0.7% TER (far lower than regular plans) |
Cost Structures Decoded: What You're Actually Paying
Mutual Funds: The Transparent Fee
(If You Know Where to Look)
India's Securities and Exchange Board of India (SEBI) regulates mutual fund fees strictly. Here's the maximum you can be charged:
Equity Funds (AUM-based slabs):
First ₹500 crore AUM: 2.25% maximum
₹500-750 crore: 2.00% maximum
Above ₹50,000 crore: 1.05% maximum
The catch: Most of this fee includes the distributor commission (1-1.5%), which is why regular plans charge so much. Direct plans skip this entirely, cutting your effective TER in half.
ETFs: The Illusion of Low Costs
ETF expense ratios average 0.48% for passive and 0.69% for active funds globally—impressive on the surface. But this doesn't include:
Bid-ask spread: When you buy an ETF, you pay the "ask" (sellers want); when you sell, you get the "bid" (buyers offer). On a ₹1,000 ETF with a ₹10 spread, you lose ₹500 immediately on a ₹50,000 investment. High-liquidity ETFs have tight spreads (0.05-0.1%); low-volume ones can reach 5%+.
Brokerage fees: Most brokers charge ₹20-50 per trade, or 0.05-0.1% for larger amounts.
Premium/Discount to NAV: Popular ETFs sometimes trade at 1-3% premiums to their actual asset value, meaning you overpay for the same holdings available at NAV in mutual funds.
The Liquidity Paradox: Why Real-Time Trading Feels Good But Costs Money
Here's where ETF marketing really shines: "Trade anytime during market hours!" In theory, this is superior to mutual funds' once-daily NAV pricing.
In practice, this feature exploits a behavioral weakness.
ETFs encourage trading; mutual fund SIPs encourage discipline.
Research in behavioral finance estimates that emotional decision-making reduces investor returns by 1-2% annually—far exceeding any expense ratio advantage. When you can trade your ETF at 10:30 AM because the market dipped 2%, you're likely locking in losses before the inevitable recovery.
Mutual fund SIPs (Systematic Investment Plans) solve this by automating deposits, removing emotion, and enforcing the only true wealth-building rule: consistency over time.
SIP vs. Lumpsum: Why Mutual Funds' Automation Beats ETF Flexibility
One feature stands alone in importance for wealth creation: Systematic Investment Plans (SIPs).
Mutual funds offer fully automated SIPs starting at ₹100-500 monthly. Your bank automatically deducts the amount, buys units at that day's NAV, and reinvests dividends. No action required—for decades.
ETFs require manual purchases or complex broker-side solutions. You can use GTT (Good-Till-Triggered) orders, but this isn't true automation.
The power of SIP lies in rupee-cost averaging:
In down markets, ₹5,000 buys more units (say, 50 units at ₹100 NAV)
In up markets, it buys fewer (say, 33 units at ₹150 NAV)
Over time, your average cost per unit drops, independent of market timing
20-Year SIP Growth: Impact of Monthly Investment Amount at 12% Returns
A 20-year ₹10,000 monthly SIP at 12% returns grows to ₹89.4 lakh—and you never had to think about it. The moment you skip even one month because the market scared you, you've broken the compounding chain.
This behavioral advantage alone justifies the slightly higher fees of a good mutual fund.
The Premium/Discount Trap: ETF Pricing Quirks Explained
ETFs trade on exchanges, so their market price can diverge from their underlying asset value (Net Asset Value, or NAV). This creates buying opportunities—or costly mistakes.
How it works:
Scenario | ETF Price | NAV | Your Cost |
Normal | ₹198 | ₹200 | Minimal (fair pricing) |
High Demand | ₹210 | ₹200 | 5% premium—you overpaid |
Low Demand | ₹192 | ₹200 | 4% discount—you saved (lucky) |
Premiums typically occur in volatile markets or with low-liquidity ETFs. For Nifty 50 ETFs, spreads are tight because competition among market makers is fierce. But for international ETFs or sector-specific ETFs, spreads can be 1-3%, eating away your returns.
The lesson: Check bid-ask spreads before trading any ETF. For international ETFs (S&P 500, NASDAQ-100), trading volumes are lower in India, making premiums more likely.
Direct Plans vs. Regular Plans: The Biggest Decision You're Not Making
Here's the one decision that dwarfs ETF vs. mutual fund debates: direct plans vs. regular plans within mutual funds themselves.
Regular Plan (bought through brokers):
Distributor commission: 1-1.5%
Total expense ratio: 2-2.4%
20-year return on ₹1 lakh: ₹3.63 lakh
Direct Plan (bought directly from AMC or online platforms):
No distributor commission
Expense ratio: 0.3-0.7%
20-year return on ₹1 lakh: ₹4.66 lakh (+₹1 lakh more)
The difference compounds to ₹13,000-23,000 per ₹1 lakh invested over 20 years—completely eliminating any advantage of an ETF.
Most investors don't even know direct plans exist. Brokers naturally steer clients to regular plans because the commission gets deducted from your returns, not their pocket. This is the largest hidden cost in Indian investing.
Global ETF Investing from India: Opportunities and Pitfalls
Want US stock market exposure? India offers international ETFs tracking the S&P 500, NASDAQ-100, and Hang Seng index.
Advantages:
Low expense ratios (0.4-0.6%)
High liquidity in US markets
Diversification beyond India
Tax efficiency
Hidden costs and risks:
Forex risk: If the dollar weakens, your ₹-denominated returns drop
Lower trading volumes in India: International ETFs trading in India have wider bid-ask spreads
Currency conversion charges: 0.1-0.3% when converting rupees to dollars
Emerging market tax complexity: Some international ETFs can be less tax-efficient due to regulatory restrictions on in-kind redemptions
A ₹1 lakh investment in a US equity ETF might cost you 1.5-2% total (spread + forex + TER) in year one, versus 0.4% for a local equity ETF.
Behavioral Bias: The Silent Cost Eating Your Returns
This is rarely discussed but arguably the most important factor.
Behavioral finance research shows emotional investing costs 1-2% annually. This happens through:
Loss aversion bias: You feel losses twice as acutely as equivalent gains. A 20% market drop triggers panic-selling; a 20% gain feels normal.
Herding behavior: You buy when friends brag about returns and sell when they panic.
Overconfidence: After beating the market once, you believe you can time it.
ETFs amplify this: Intraday pricing and the ease of trading encourage you to act on every news headline. Mutual fund SIPs force you to stay the course.
Mutual funds mitigate this: You can't easily redeem mid-panic (it takes a day); your SIP keeps buying during crashes (when you should be accumulating).
Over 20 years, the discipline premium from a mutual fund SIP often exceeds any cost differential with ETFs.
Who Should Choose What: A Decision Framework
Based on comprehensive research, here's who benefits most from each vehicle:
Investor Type | Best Choice | Why |
Experienced investors, active trader | ETFs | Real-time trading, lower fees, tax efficiency |
Working professional, age 25-45 | MF SIPs (Direct Plan) | Automation, discipline, no temptation to trade |
High-income earner, tax-conscious | ETFs + Tax-loss harvesting (with guidance) | Deferred capital gains, flexibility |
Disciplined saver, long-term horizon (10+ years) | MF SIPs (Direct Plan) | Rupee-cost averaging, compounding benefits |
Short-term trader (< 1 year) | ETFs | Liquidity, minimal exit friction |
Recent Game-Changer: SEBI's December 2025 TER Reduction
In December 2025, SEBI approved significant expense ratio cuts to boost retail participation:
Index funds and ETFs: TER reduced from 1.00% to 0.85%
Equity funds (regular): Up to 0.15% reduction
Debt funds: Proportional cuts across AUM slabs
This narrows the cost advantage of ETFs over low-cost mutual fund index schemes. A direct plan index mutual fund now costs ~0.5-0.7%, competing directly with ETFs at 0.4-0.6%.
The Numbers Don't Lie: A Realistic Comparison
Let's model three realistic scenarios for a ₹5 lakh investment:
Scenario 1: Direct Mutual Fund SIP (₹10,000/month for 50 months)
Fund: Large-cap equity (direct plan)
Expense ratio: 0.5%
Expected return: 12% annually
20-year value: ₹27.85 lakh
Total cost (all fees): ₹2.15 lakh (7.2% of gains)
Scenario 2: Low-Cost Equity ETF
Fund: Nifty 50 ETF
Expense ratio: 0.35%
Bid-ask spread: 0.15% (average, liquid ETF)
Expected return: 12% annually
20-year value: ₹28.12 lakh
Total cost (TER + spreads): ₹1.88 lakh (6.3% of gains)
Scenario 3: High-Cost Regular Mutual Fund
Fund: Active equity (regular plan)
Expense ratio: 2.0%
Expected return: 12% annually
20-year value: ₹25.36 lakh
Total cost: ₹4.64 lakh (15.4% of gains)
Verdict: ETF wins on cost, but if you're choosing between a direct mutual fund and an ETF, the difference shrinks to 0.24 lakh (0.8% of final value). However, the mutual fund's SIP automation might save you 1-2% in behavioral costs, flipping the advantage back to the mutual fund.
Addressing Common Myths
"I should choose whichever returned the most last year." Past returns are not predictive. Even SEBI warns about this. Choose based on structure, costs, and your behavior, not past performance.
"Lower NAV means cheaper." This is dangerous myth. A direct plan has a higher NAV than a regular plan of the same fund, but it's cheaper because fees are lower. What matters is final value, not NAV per unit.
"ETFs are too risky because prices fluctuate." The prices fluctuate because they trade intraday, not because they're risky. The underlying holdings are identical to mutual funds.
"I can't afford ETFs because one unit costs ₹200." Most brokers now allow fractional ETF purchases (buy 0.5 units), eliminating this barrier.
The Final Word: Structure Beats Effort
The difference between 12% annual returns and 10% annual returns—a mere 2% gap—compounds to 60% more wealth over 30 years (₹1 crore becomes ₹1.6 crore).
You cannot close this gap through stock picking, timing, or mutual fund switching. It comes exclusively from lower fees and behavioral discipline.
Whether you choose ETFs or mutual funds matters far less than:
Choosing direct plans over regular plans
Committing to a 15+ year horizon
Automating investments (SIP)
Ignoring market noise
An ETF with poor discipline (frequent trading, panic selling) will lose to a mutual fund SIP with consistent monthly investments. Conversely, a disciplined ETF investor beats an emotionally reactive mutual fund investor.
Pick the structure that matches your personality. Then disappear for 20 years.
Key Takeaways
Direct mutual fund SIPs are the default choice for most Indians earning ₹8-50 lakh annually
ETFs suit experienced investors comfortable with intraday trading and research
Expense ratio differences matter, but behavioral discipline matters more
A ₹1 lakh investment over 20 years will earn you ₹1-2 lakh more if costs are 0.5% vs. 2%
December 2025 TER cuts have narrowed the cost advantage of ETFs significantly
Never buy regular mutual fund plans; direct plans cost 1.5-2% less annually
Disclaimer: This content is for informational purposes only and does not constitute financial or tax advice. Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.
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