What Are Index Funds and ETFs–Maybe Not What You Think
February 22, 2019
Index funds and ETFs (Exchange Traded Funds) are a part of investing conversations everywhere right now. We look at how these two great tools can be part of building your financial future. The essentials that you need to know.
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Welcome to today’s episode of The Simple Plan broadcast and podcast. Today we’re going to talk about index funds and ETFs or exchange-traded funds. They’re a big topic of conversation these days and I just want to give you a bit of clarification that sometimes people get confused about. We’re undergoing a profound shift in Canadian investing. People are looking at alternatives to traditional investing such as mutual funds and stocks.
Two ideas you hear mentioned regularly now are index funds and ETFs, short for exchange-traded funds. Often they are talked about as if they are the same thing, though they’re not. Today I want to help you clarify in your thinking what these two investing ideas or opportunities are about.
An index fund is a mutual fund that tracks, or attempts to duplicate, the performance of an investment index. While you may not be clear on what an investment index is, you have heard about them if you have ever listened to any news reporting on business. The most well-known investment indexes are things like the TSX Composite index which measures the performance of stocks traded on the Toronto Stock Exchange. The S&P 500 Index measures the performance of 500 stocks which trade on exchanges in the United States. The Dow Jones industrial Average, or simply the Dow, is another commonly commonly quoted index. There are indexes for almost any investment type you can imagine. For example the MSCI EAFE measures stocks in Europe Asia and the Far East.
So an index fund simply seeks to replicate the performance of a particular index. For example you can buy an S&P 500 Index Fund from a variety of sources which should give the same performance as the S&P 500 Index.
There are indexes which track the performances of bonds as well, and indexes which track the performance of balanced funds, and many many others.
So when you buy an index fund you’re buying a fund that should give the same performance as the index you have selected. If you want a fund that tracks the performance of the broad array of US stocks , you might buy an S&P 500 Index fund.
Index funds have no active management. This means that no one is examining the stocks contained in the index and deciding whether those are good or poor. This is in contrast to traditional mutual funds, which have a fund manager who makes decisions about buying and selling stocks or bonds in the mutual fund, based on the manager’s view of that stock or bond. That traditional approach is called active management.
Index investing is passive because the performance of the index is determined by the performance of the stocks tracked by the index, which is simply a function of the market. The performance of an index is not affected by any manager making a decision about the quality of a stock or bond and then buying or selling stocks or bonds for the index.
One very significant aspect to index funds is that there is no manager, and so this helps to reduce fees. There will still be some fees charged to make the fund available and to cover costs of trading in the fund. One of the reasons index funds have become so popular is that they have lower fees. We’ll discuss fees another day.
Now an ETF or exchange-traded fund, is really about how or where you buy the fund. There are many ways to buy investment funds. You might have a professional adviser who obtains funds for you. You might buy funds at the counter at a bank. In those cases you do not buy the fund directly, you need someone with access to the fund purchase system.
An ETF or exchange-traded fund is just what it sounds like, a fund that is traded on an exchange. This means that individual investors can get access to purchase funds directly. Individual investors might buy an ETF using an online brokerage such as questrade. Or they might buy an ETF using a robo advisor, and just to make things confusing you can buy an ETF through a traditional advisor or at the bank.
Initially ETFs primarily offered index funds, and so people began to think of them as the same thing. Today there are many types of funds available as ETFs, including many actively managed ETFs. Remember when a fund is actively managed there is a person making buying and selling decisions about the stocks and bonds in the fund. And that person is being paid to do that so there will be fees to cover those costs.
Using ETFs may also reduce fees as there may be no advice being given, and it’s cheaper to operate an online trading system then it is to operate a system of fancy offices and branches.
So the informed investor needs to know what they’re looking for. If you’re looking for Passive investing that simply tracks the performance of a certain Market you want an index fund. If you want to do it yourself you will then want to get access to this Index Fund through some type of exchange that you can access and you will purchase this Index Fund as an ETF or exchange-traded fund.
But remember just because you’re buying an ETF doesn’t mean it’s an index fund or the fees are lower. You can buy expensive, high-fee, actively managed mutual funds as an ETF. And you can also buy low-fee index funds as an ETF. Just always be clear before you make your investment purchase that you know that you’re getting what you’re looking for.
If you need assistance in your investment planning and decision-making it’s a good idea to use a good advisor with the heart of a teacher. Some financial advisors are now making low fee index and ETF options available to their clients, giving investors the best of both worlds, good professional advice with lower costs. That’s a good thing, and I expect that trend to grow in the future.