More and more people are moving from an active fund management approach to a passive fund management one. Investors are looking to invest in Exchange Traded Funds (ETF’s) but what are they? Is there a difference between an ETF and an Index fund?
There is repeated evidence that funds that try to mirror the returns of the market do better than actively managed funds that try to beat the market. Rather than investing in a fund manager, you buy shares in an ETF and harness the power of the market itself. If markets go up, your ETF goes up, if markets go down, your ETF goes down. There is no flee to cash in times of market volatility. This passive approach has shown to produce great returns than most active managers over the long term.
An ETF follows an index, that is it tracks a certain category of stocks. A commonly cited index is the S&P 500, which is the top 500 companies in the US according the Standard & Poors (S&P). The makeup of the index is based on their market weighting. Apple is the biggest company in the index so they will have the heaviest weighting. News Corp Class B is the smallest company in the index so they will have the smallest weighting.
An ETF that follows the S&P 500 will buy the index information from S&P and copies it. There are thousand of ETF’s in the market, following all sorts of indices. An important measure of an ETF is its tracking error. An aim of an ETF is to copy the index that it is following, so their returns should be the same. The tracking error is the difference between the returns of the index and the actual return achieved by the ETF. If there is a big tracker error, the ETF is doing something wrong.
Both an ETF and an Indexed Fund track an index. But as the name Exchange Traded Fund suggests, an ETF is a fund traded on a stock exchange, just like a stock is traded. Its price goes up and down throughout the day. An index fund is not traded on the stock exchange, it operates is a mutual fund and is priced at the end of each day.
ETF’s are not trying to beat the market, they are trying to capture the returns of the market. An active fund manager is trying to beat the returns of the market. This costs money as they have to hire people to analyse the companies that may be of interest or they may have to travel to meet the CEO’s of companies they are interested in investing in. They also trade a lot more often in their bid to beat the market. It costs money to trade, so the more you trade, the more it costs. The costs come out of your money so the higher the charges, the less money in your investment.
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