What is Indexing?
If you want to track the market, the best way to do that is to buy all of the assets in that market in the correct proportion. For example, if you wanted to track the S&P 500, you could buy all of the companies listed on that index in the proportion that they are represented in that index. So if company A made up 5% of the S&P 500, 5% of your investments would be in that company.
Of course, there are problems with that. The S&P 500 index is comprised of around 500 companies listed on the NYSE (New York Stock Exchange). Imagine buying shares in 500 companies. There would be large dealing charges associated with that and it would be very time-intensive. You would also have to rebalance your portfolio constantly.
One way around this is to buy an Index fund. An index fund does what it says on the tin. It tracks an index. If you invest £1000 in an index fund tracking the FTSE 100, you will own the underlying securities listed on that index, in the correct proportion. You do this by buying into one fund. Tracking an index is a really simple and cost effective way to invest in the market.
Index Funds/ETFs can Track The Same Index
A lot of terms are thrown around in the fund industry. One thing which confused me at the start was comparing the difference between an index fund and an index ETF (exchange traded fund). If you were to assume both track an index, that would be the correct assumption. If you buy a FTSE 100 ETF or a FTSE 100 Index Fund, you will be tracking the FTSE 100 index. You will own the underlying assets that make up that index in either the ETF of the Index Fund. Of course, there are a few differences.
A Note On Full Replication vs Optimised Sampling
It must be noted that some indices track more companies than others and this has ramifications in the index fund industry. An index fund tracking a smaller index (eg. fewer companies), can easily buy all of the underlying securities. This is called “full replication”.
A fund tracking a larger index (eg. thousands of companies) might use what is called “optimised sampling”. If the fund uses optimised sampling, it doesn’t hold all of the underlying securities but it owns a large number of them. The aim here is to be representative of the index, without owning all of the underling securities. Both index funds and ETFs can use this approach.
Buying/Selling Index ETFs vs Index Funds
"Is an ETF the same as an index fund?" is a commonly asked question. The answer is, not exactly. An ETF is like a stock traded on the stock exchange. Like any stock, you can buy and sell an ETF at different points throughout the day. You can trade ETFs through stockbrokers or via a fund platform. Index funds can be bought through a fund platform or through the company that created the fund (eg. Vanguard).
The ETF is priced throughout the day, similar to any stock actively traded on the stock market. But an index fund is priced at the valuation point of the day (usually market close). The way you buy and sell an ETF vs a fund is really the biggest difference. You might look at both and then say, why would I invest in an index fund when I can trade the equivalent index ETF like a stock? Surely, that gives the investor more control. True, however there are some things you must take into account.
The Middle Of The Day?
The best way to highlight how ETFs can be misused is through a quote from one of my favourite investors:
“The middle of the day? I mean, come on” - John Bogle Vanguard Founder and ex-CEO
The index fund was created to track the market over a substantial period of time. Let’s say an absolute minimum of 5 years. It is to hold the market, not to trade the market. An ETF marketer will tell you one of the biggest selling points of an ETF is that you can trade them at any point throughout the day. But logically if your strategy with an index tracker is to buy and hold for the long term, this shouldn’t really be a large advantage.
Put another way, imagine selling at 1pm in exactly 10 years from now vs 5pm in exactly 10 years from now. It isn’t really a selling point that you should concern yourself with too much.
Detaching Yourself From Market Fluctuations
In my opinion, there is a psychological advantage that index funds offer over index ETFs. Investing for the long term requires courage and consistency in the face of rising (bullish) and falling (bearish) markets. You will do well if you consistently invest during both rising and falling markets. In fact, during a market crash you will be getting more for your money. Investing more during the bearish times will mean you have more invested when the markets eventually turn around and start to rise again.
The more you can automate this process, the more you can detach yourself from your index, the greater likelihood that you will not sell at the wrong time. You can do this in a few ways. You can automate processes, set up automatic dividend reinvestments and direct debits.
In my experience, index funds facilitate automation. Whilst some platforms offer automatic dividend reinvestments, some do not. Some charge for dividend reinvestments, some do not. This really depends a lot on the platform you are using. Accumulating index funds automatically reinvest dividends in the fund at no extra charge. From your point of view, you will just see the value of your fund increase. This keeps it simple and detaches you from your investments, reducing the likelihood that you trade based on emotion rather than logic.
Things To Think About
If you want to invest in the market for the long term, index funds and ETFs offer you the ability to do so easily and cost effectively. When deciding between the two, here is what I took into account:
This includes ongoing fund charges, ongoing platform charges, dividend reinvestment charges, dealing charges. Take all of these into account if you are looking at either the index ETF or the index fund. If you adhere to the practice of dividend reinvestment for long term growth, then making this process as easy as possible will benefit you.
The Funds/ETFs available From Your Chosen Provider
If you prefer one fund provider over another, then you have to take into account what they offer and in what form. For example, lets say you want to track the American equity market. One provider might offer a S&P 500 ETF and a US Equity Index Fund. They are similar in that they both track companies listed on the NYSE (New York Stock Exchange) but the US Equity Index Fund includes small and medium-cap companies as well as large caps. Although both are cap-weighted, driven mostly by the value of larger companies, the difference between the two should not be ignored. Decide which index you want to track, make sure you are tracking the correct index and then find a provider which allows you to do so cheaply.
If an ETF is distributing (pays dividends), it will accumulate cash dividends and then provide you with an income, usually every quarter. Accumulating Index funds reinvest dividends immediately. If you value dividend reinvestment and you want to optimise this so dividends are immediately reinvested, with no waiting period, the index fund may be the correct choice.
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