Definition and Examples of Index ETFs
Index ETFs are exchange-traded funds that aim to replicate and track a benchmark index such as the S&P 500.
Index ETFs are designed to track the performance of a primary stock market index – such as the Dow Jones Industrial Average, the S&P 500, and the Russell 2000 – or a targeted segment of the broader market. These funds allow individual investors to gain exposure to a comprehensive index of stocks. Many of the largest ETFs are index ETFs.
Note: The performance of an index ETF may not exactly reflect the underlying index due to slight differences in the value of the fund versus the market price of the fund.
How Index ETFs Work
The underlying index of an index ETF is often created and managed by a single company, which then licenses it to an ETF management company. The ETF’s prospectus will outline how the index is constructed.
ETF managers strive to replicate the performance of the index by including the same assets and trading decisions as the underlying index fund. Index ETFs trade actively in the market just like stocks. Sometimes, their net asset value (NAV) may differ from the trading price, but this does not persist for long.
Note: Some of the most well-known fund companies for ETFs include Vanguard, iShares, Invesco, and State Street Global Advisors.
Index ETFs vs. Mutual Funds
In many ways, ETFs are similar to mutual funds. Both rely on pooling money that is invested according to an objective or strategy expressed in the fund’s prospectus. While most mutual funds are managed by a professional fund manager, most ETFs are passively managed (only changing when the underlying asset allocation of the index changes).
Review the differences between ETFs and mutual funds before deciding which is best for your portfolio.
Note: When purchasing an ETF, you are not buying it directly from the fund company. Instead, you are buying it from a third party known as an authorized participant (AP) who deals in buying and selling the underlying securities of the ETF.
What This Means for Individual Investors
Index ETFs provide a lot of flexibility for individual investors. You can:
– Start a retirement account and invest everything into an S&P 500 index ETF while benefiting from long-term compounding and potential returns from a diversified stock portfolio.
– Use index ETFs to create a smart asset allocation portfolio to diversify investments across different asset classes for better returns with appropriate risk levels.
– Use unconventional index ETFs to invest based on value or quality or your personal ethical principles.
Note: The primary alternative to index ETFs is mutual funds. You may be familiar with these funds if you have made investment decisions in a 401(k) account, for example.
Generally, index ETFs are considered better than mutual funds for the reasons mentioned above, including lower fees and better tax efficiency. However, if you are limited to mutual funds in a 401(k) account or similar investment scenario and adhere to smart investment principles, you can still benefit from their long-term advantages.
Key Takeaways
Index ETFs invest a pool of funds in an attempt to replicate the performance of a primary index. Index ETFs trade on the exchange like stocks. Overall, index ETFs tend to have better fees and tax efficiency than mutual funds. You can use index ETFs for diversification and other strategies as an individual investor.
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Sources:
– State Street Global Advisors. “SPDR S&P 500 ETF Trust.” Accessed Sept. 9, 2021.
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IRS. “Topic No. 409 Capital Gains and Losses.” Accessed Sept. 9, 2021.
– Investment Company Institute. “Trends in the Expenses and Fees of Funds, 2020,” Page 2. Accessed Sept. 9, 2021.
Source: https://www.thebalancemoney.com/what-are-index-etfs-5200771
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