Two of the largest trends in retail stock market investing in the last two decades can be reduced down to two investment types – index funds and exchange-traded funds (known as ETFs for short). Both are credited with giving retail investors a cheap way to gain exposure to stock market and bond market returns.
Like any financial product, institutions have continued to innovate and launch new variations. These include new features which are at odds with the philosophy of the original products, and they are starting to push the boundaries of the definitions themselves. This is introducing some confusion between index funds and ETFs.
In this article, we’ll explain what makes an index fund an index fund, and how they differ from exchange-traded funds ETFs. We’ll also highlight why these investment vehicles have been increasingly recommended by stockbrokers to their clients since the 2000s.
Definitions and meanings
Both index funds and exchange-traded funds are examples of collective retail investment schemes. A collective investment scheme receives cash from a pool of retail investors and invests it according to a specified investment strategy. The investors are provided units or shares in the fund, proportionate to the value they invested and the value of the fund at the time.
The fund manager appoints a team of finance professionals who select investments for the fund and manage the liquidity of the fund to ensure that redemption requests or new investments are efficiently handled. The fund manager receives a management fee, typically levied as a percentage of the total assets held in the fund, e.g., 1% per annum.
Investors are prepared to pay a management fee because they save transaction fees versus managing their own portfolio, and it frees them from spending time monitoring the performance of each asset in the portfolio. This approach of outsourcing the investment activities to an experienced third party is keenly taken up by most investors as they may not have the time or desire to spend several hours each week managing a stock portfolio.
An index fund is an unlisted mutual fund that follows an index-tracking investment strategy. An index is a weighted average price that represents the combined value of a basket of securities. The Standard & Poors 500 index, for example, measures the combined price of 500 of the US stock market’s largest and most liquid listed businesses.
An S&P 500 index fund will seek to track or replicate the performance of that index by holding the same basket of securities in its investment portfolio. If an index fund holds the same weighting of investments as the index it is tracking, the performance of that fund should also correlate very closely.
An index fund will be highly diversified because stock market indices often contain 100 or more investments. While an index fund may not strictly buy every single asset which makes up the larger indices, it will buy such a large proportion that an investor will enjoy lower volatility, as if they had invested in the separate assets themselves.
An index fund will usually carry lower fees than an ‘active’ fund manager that buys original research to guide their investment decisions. This is because an index strategy is largely mechanical – a simple computer algorithm will guide the small team to make the appropriate trades needed to match the index.
Exchange-Traded Fund (ETF)
An exchange-traded fund is a fund that is listed on a public stock exchange. Most collective investment vehicles are private trusts or companies, which means that an investor cannot buy or sell units directly on the stock market. Instead, the fund manager will typically process withdrawals and deposits themselves at the close of the working day. These trades will occur at a single daily price calculated by the fund manager themselves.
Exchange-traded funds can be traded like any other tradeable stock. This means that they can be bought or sold at any time during the trading hours of the stock exchange on which they are listed, at prices set by the market participants. The trading hours of stock exchanges is typically between 8:30 am and 5 pm in the local time zone.
This provides new options to short term traders, known as day traders. They can buy an ETF in the morning and sell the same fund in the afternoon. This is not possible with other fund types. Through their best stockbroker, retail investors can now buy and sell funds with the same ease as other stocks.
Difference between index funds and exchange-traded funds
Index funds and exchange-traded funds are often conflated because these two concepts can overlap.
- Index tracking is a type of investment strategy
- Exchange-traded is a type of legal structure
These terms describe different aspects of a fund and therefore the two definitions aren’t mutually exclusive. An exchange-traded fund can also be an index fund.
This is true of the largest exchange-traded fund as of the date of writing. As of August 2021, the largest ETF is SPDR S&P 500 ETF Trust (SPY) managed by State Street. It is listed on the New York Stock Exchange and tracks the Standard & Poors 500 index.
- Not all index funds are traded on an exchange – many are private.
- Not all exchange-traded funds track an index – others may pick stocks at the discretion of the fund manager with a view to outperform an index of similar companies.
Conclusion – index funds vs exchange-traded funds
While some popular exchange-traded funds follow an index-tracking strategy, ETFs and index funds are separate concepts.
ETFs are highly accessible collective investments that can be bought and sold at any time during market hours using a stockbroker.
Index funds follow an investment strategy where the fund manager manages the investment portfolio to mirror a target stock market index so that the performance of the fund closely tracks the performance of the index.