Indices vs. Index Funds vs. Exchange Traded Funds (ETFs)

One question that we get asked a lot is, “What is the difference between an index, an index fund, and an exchange traded fund (ETF)?”

The short answer is that you cannot buy an index (it is a formula to value a market) but you can buy an index fund (which typically trades like a mutual fund), or an ETF (which typically trades like a stock).

At CJ Capital, we prefer to use ETFs for our personal portfolios for investments in the range of $5,000 or greater. This is because although ETFs typically have lower annual fees than index funds, they do have upfront trading costs that are only justified on these larger transactions.

Read on for a more detailed answer to the question…

Index

An index is a mathematical formula to measure the value of a market. Once a consistent methodology is applied to determine the value of a market, the performance of the market can be determined.

An index is comprised of various securities in the market according to a defined weighting formula. Examples of well-known indices include: Dow Jones Industrial Average, Standard & Poor’s 500 (S&P 500), and in Canada, the S&P/TSX 60. Indices can also be made for specific regions, ex: FTSE EAFE (Europe, Australasia and Far East), or sectors, ex: UTIL (Dow 15 Utilities).

Weighting methods include:

• Price weighting (ex: Dow Jones Industrial Average): The price per unit of the security is used to determine the relative amount of the index that the security comprises. The index is typically adjusted for stock splits, and other weighting effects. High priced securities will dominate the index.
• Equal weighting (ex: Barron’s 400): All securities are equally weighted in the index. Small companies may dominate the index as there are typically more small companies than large companies in a given market.
• Market capitalization weighting (ex: S&P 500): The most common index weighting system. Securities are weighted in the index according to the market capitalization (share price times shares outstanding). These indices can also be float adjusted (non-trading blocks of shares are removed from the shares outstanding).

An index cannot be purchased directly as real-world transaction costs are necessarily incurred in order to purchase and sell the securities comprising the index. Examples of events requiring transaction costs include: weights of the securities in the index being adjusted due to changes in market capitalization, new securities entering the index, and existing securities leaving the index.

As a result, investment vehicles such as Index Funds or ETFs are used to track the performance of the index as closely as possible.

Index Fund

An index fund is typically a mutual fund that attempts to track a market index as closely as possible in order to minimize tracking error. Index funds typically purchase all the securities in an index in the same proportions as the index weightings, or as close as realistically possible.

As index funds do not require active management (investment manager judgment), they typically offer lower fees than traditional mutual funds or other actively managed investments. In addition, as indices typically reconstitute (adjust their weightings) less frequently than an actively managed fund would, index funds offer the benefit of less frequent trading of their constituent investments, and thus taxes on capital gains are deferred and paid less often.

Index funds are typically purchased in the same way as conventional mutual funds, in that they can be purchased by going into a bank branch, speaking with a bank investment representative, or making trades via an online brokerage account. As with other mutual funds, index funds typically only trade once per day at a single price calculated for that day. Index funds typically do not have transaction costs to buy or sell them, although there are variants that exist with these fees.

Examples of index funds include: TD e-Series Funds, as well as numerous offerings from RBC, BMO, and other financial institutions.

Exchange Traded Fund (ETF)

An exchange traded fund (ETF) is a fund that is traded on a stock exchange such as the TSX or NYSE, in a manner similar to conventional equity stocks. As with a stock, an ETF price is available as a series of quotations throughout a trading day, rather than only a single price calculated at the end of the trading day, such as with an Index Fund. ETFs typically track an index, like Index Funds.

ETFs are purchased and sold in a similar manner to a stock, in that an investor needs to be aware of the bid-ask spread of the fund and may wish to employ stop and/or limit orders to provide price assurance on their transaction. ETFs require transaction fees to buy and sell them, which typically will necessitate larger order sizes, such as $5,000 or more in order to justify the transaction fees. However, ETFs typically offer the lowest annual management fees of all passive investments, due to their size, structure, and taxation.

Often, even though ETFs require fees to buy and sell, they are the most cost effect passive investment to track an index and are the preferred passive investment for CJ Capital’s personal investment portfolios.

Examples of ETFs include iShares S&P/TSX 60 Index ETF (XIU) and Vanguard FTSE Canada All Cap Index ETF (VCN).