Many financial personalities on television and in self-help books recommend individuals buy index funds, and they also recommend individuals buy exchange traded funds (ETF). But, many investors simply do not understand the difference between the two investment products and how they can fit into your balanced investment portfolio. What is the difference between index funds and exchange traded funds? There are many similarities and a few differences as well between the two investments. You should think of the two as a venn diagram where there is an overlapping area but also mutually exclusive areas.
What Are Index Funds?
Index funds are simply funds that track a major index. The major indexes include the Dow Jones Industrial Average, the Standard and Poor’s 500 (S&P 500), The Wilshire 5000, and others. In the United Kingdom, you have the FTSE 100 (similar to our S&P 500). Overseas, you also have the various MSCI indexes that track various developed and emerging markets overseas. Indexes themselves are not traded, and that is where index funds come into play. If you want to mimic the performance of an entire index, you should invest in an index fund. There are thousands of index funds since almost every brokerage house tends to have their own index fund that tracks most indexes worldwide. As a result, there are many options for investors who are looking to invest in even the simplest standard indexes like the S&P 500. Typically, investors purchases shares of index funds exactly like they do with actively traded mutual funds.
What Are Exchange Traded Funds (ETF)?
ETFs, or exchange traded funds, are another type of investment vehicle similar to index funds. Exchange traded funds are like mutual funds, in that they hold a basket of stocks in a single fund for investors to purchase shares of. But, unlike traditional actively traded mutual funds which only reset their prices and execute orders at the end of the trading day, exchange traded funds trade on the open market at all times like shares in an individual common stock. As a result, they act more like a stock on daily basis with fluctuations that are the result of the real time supply and demand for that investment at that given point of time. ETFs are similar to index funds in that a lot of ETFs mirror the market like an index funds by only holding the exact same securities that comprise the index. But, you can also find ETFs that specialize in a huge number of other investment choices, sectors, commodities, and other specialized investment choices that you cannot find in an index fund.
The number of choices in investment vehicles for investors now is simply amazing. There are thousands of exchange traded funds that invest in wide, diverse underlying investments. If you want to find an ETF that specializes in agriculture stocks, there is fund for that. If you want an ETF that invests in nano-technology companies or social media companies, there are funds for that as well. The possibilities are only limited by your imagination and desire to invest in ETFs that specialize in these fields. But, if you want to invest in the broad economy, then index funds offer investors a great opportunity to earn a return that mirrors the specific stock market that the index fund is following.