Investors sometimes use ETF and index funds interchangeably which can confuse that both things are the same.
A common question people ask is are there differences between exchange traded funds and index funds? and if so which is better ETF vs Index Fund? and how do you go about investing in an index fund?
What is an Index Fund?
Index funds are funds which aim to replicate the performance of a specific market index (like the S&P/ASX 300). Index funds are passive funds because the funds are designed to track the performance particular indicies rather than actively trying to pick stocks that look to be winners and losers. At the end of the day the index fund aim simply to provide the return of the market.
There are a variety of index funds with each tracking a specific index. Examples include asset class specific indexes across equities, bonds and commodities. There are also a variety of indexes within an asset class. For example there are indexes tracking specific country markets such as S&P 500 (for the US) or group of market such as emerging markets.
The low management fees can be considered the main advantage of investing in an index fund.
In the last 2 decades the passive investment industry has been eating active managers lunch. The funds management industry have been woefully in delivering market beating performance where the biggest secret is a portfolio of index funds is the best option for a large portion of the population.
A typical index fund expense ratio are in the range of 0.20% to 0.40% a year. This is can be a fraction of active funds where typical 1%+ fees can be expected. Over the long run the difference compounds which can result in a large difference in the investment portfolio.
What is an ETF?
Exchange traded funds are index funds which are listed on a stock exchange such as the Australia Stock Exchange. These funds like the unlisted index funds are open ended which in addition to buy and selling units of these funds on the exchange, investors can also purchase and redeem units in the underlying trust at a time of their choosing. There is simply no minimum commitment period required for the investment.
Take the ASX 200 ETF (ASX STW) for example, the investment mandate of STW is to replicate the performance of the ASX 200 Index. Overtime the returns of STW tracks closely to the performance of the ASX 200 index less any fees paid to the manager in managing the investment. Since these are passive funds where there is limited active involvement by the manager aside from quarterly rebalancing, the fees for these products are extremely low compared to actively managed funds.
ETF vs Index Fund
The key difference between ETF vs index funds is that only because it is a index fund does not mean it is listed and tradeable on an exchange. All ETFs by definition are listed and tradeable.
How to Invest in Low Cost Index Fund?
Major investment or wrap platforms will look to provide low cost index options. If they don’t, then they are not even worth considering because all that is left is just high cost investment profits with fat commissions for the advisers.
Investing in index funds should be as easy as choosing the index fund option, usually the product description clearly state that they track the market only (as mentioned previously they do not pick stocks). The key consideration is an investment allocation question of what market the investor want exposure to and how much of it in the portfolio. This is very dependent on individual circumstances.
Types of Index Funds
There could still be a twist to traditional index tracking fund in addition to just track the major indices like the ASX20.
Recently there has been an increase shift towards factor investing which look to expand the index universe from just market cap weighted index funds to factor based funds. This has expanded the investable index funds universe to include dividend index funds such as high yield funds like ASX VHY which aim to purchase stocks which only meet a specific dividend yield threshold or history of paying dividends.
Separately, there are also sector specific funds which focuses on equities only in a single sector like resources, financials or Australian real estate investment trusts (AREIT).
There are also commodity ETFs which provide specific commodity exposure like copper, gold or silver.
Direct Indexing
Direct indexing is a slight variation of separately managed accounts for large institutional investors. Direct indexing funds are custom portfolio created specifically for an investor based on their requirements or needs.
This could be driven by index providers having a specific set of rules in deciding whether a stock should be included in an index. The investor could have a different view on these rules and look to take the existing index as a starting point rather than the ending point and add or subtract companies from the index per their own requirements. There is a strong shade of active management in direct indexing approach of investing.
What is Active ETF?
Exchange traded funds were traditionally known as passive investment vehicles and is an efficient means for investors to compound long term returns in a cost effective manner.
Recently there has been a trend to develop active ETFs which extend the investment range of ETFs beyond its historic role as a passive index tracker.
The introduction of smart beta funds (or factor investing funds) was the first step which select stocks based on a specific investment factors and the industry has increasingly shifted to create actively managed exchange traded funds.
Active ETF can simply be considered managed funds that are traded on the exchange. This is very similar to Listed Investment Companies which is just a listed closed ended funds which started with a fixed amount of capital. The difference here is active ETFs are open ended funds. The total size of the active ETF portfolio will change based on investor demand, capital inflows and outflows in the fund.
Actively managed exchange traded funds can be a viable if the fund outperforms a particular benchmark. Paradoxically this has been the key factor driving investors towards passive management, most active funds after fees have not been outperforming the benchmark. The growth in passive investing is result of many investors giving up on active management.
It is yet be seen that investors have taken much interest in active ETF even though the investment managed have been creating these products.
We are by no means great cheer leaders of passive management, we are active investors first and foremost and consider it to be the best means of creating value over the long run. But active investing is not for everyone.
For most, passive funds is the most efficient means of allocating capital, putting aside the fact the growth of passive capital can in some instances create distortion in the market in which the capital allocation is effectively blind.
We consider the creation of active ETFs as a rear guard action in stopping the outflows. However until the underlying driver of investors moving from capital from active to passive is addressed, i.e too many funds underperform their benchmark and fails to add value. Passive investing will continue to eat active management’s lunch.