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Don't invest in an ETF until you've watched this video.
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Hi, I'm Kylie and part of my job is to write about index funds and ETFs. One of the most common questions I get is what is an index fund and how is it different to an ETF? And I get why it can be confusing. These two terms get thrown around like they're the same thing. But here's the twist. Sometimes they're the same thing and sometimes they're completely different.
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So, I'm going to break that down and I'm also going to show you step by step how you can tell the difference and where you actually find that information before you invest.
0:35 Index Funds
Okay, so let's start with index funds. At its core, an index fund is a type of investment fund that aims to track a specific market index like the ASX 200 or the S&P 500. And you might ask, "Okay, what is an index?"
0:51 What is an Index?
Really simply, an index is a list of stocks, typically major stocks, that represent an entire market. So the ASX 200 is just a list of Australia's biggest 200 stocks. And the S&P 500 is a list of the 500 biggest public companies in the US.
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So an index fund buys most of or all of the stocks in whatever index it's tracking. And if that index goes up, well, your investment follows. But here's the thing. An index fund describes the strategy, but not the structure. So you can invest in an index fund in a couple of ways.
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You can invest using an unlisted managed fund and that includes things like your superannuation or a regular managed investment fund. Or you can invest in an index fund through an ETF, an exchange traded fund.
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These are just investment funds that you can buy and sell on the stock market just like shares. So in Australia, at least when someone says index fund, they might be talking about a traditional fund or they might be talking about an ETF that tracks an index. Okay. So now to ETFs.
1:52 What are ETFs?
ETFs are a structure, a type of investment product, not a strategy. And of these very loosely, you have passive ETFs, which are index funds, and active ETFs, which is where a fund manager is picking stocks to try and beat the market.
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So, for example, you might have an S&P 500 index fund, which is simply passively tracking the market. In this case, the S&P 500. Index fund managers have the easiest job in the world, which is why the fees to invest in an index fund are so low.
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Then you have active funds that are trying to beat the S&P 500. They're trying to beat the market.
So, fund managers in this case believe that by actively buying and selling stocks and other types of assets, they can deliver higher returns than the market can, and they'll usually charge higher fees for their service.
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So yes, all index ETFs are ETFs, but not all ETFs are index funds. And in fact, these days, ETFs can invest in just about anything, and they have all sorts of different structures and strategies.
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So you've got ETFs that now hold stocks, property, cryptocurrency, gold, you name it. Some ETFs now are also very complex. Some short the market, so they deliver returns when the market is falling. Others use leverage to inflate their returns and by extension also inflating losses.
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And there are also a lot of thematic ETFs. So you can see the best performing ETF in Australia over the last 12 months was the Beta Shares video games and e-sport ETF. It returned 57.63%. That is an ETF that invests in video game and e-sports stocks which is pretty wild. Pretty wild. Slow down.
3:27 How to tell if an ETF is an index fund?
Okay then. So, how do you know if the ETF you want to invest in is actually an index fund? This is a really good question and a super important one. So, I'm going to share a couple of ways you'll be able to tell the difference.
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So, firstly, look at the name of the ETF. ETF providers are required by ASET to label their ETFs when they're actively managed or when they are more advanced or use riskier products like leverage or derivatives.
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For example, actively managed ETFs use the word active in their name. ETFs that use leverage or short the market or use complex derivatives must use the word complex. If the ETF doesn't have either of these labels in their name and it includes the word ETF in the name, it's probably a passive index fund. And that's where the second check comes in.
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Before you invest, you need to check the ETF provider page. You need to read the PDS, its product disclosure statement, as well as its target market determination, it's TMD. So, let me show you how it's done.
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So I'm looking here at the Betashares Financial Sector ETF and I want to check whether that is a passive index fund. In this case presumably tracking financial sector stocks within an index. So I'm going to go to the page and I'm going to search for the target market determination.
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Here it is. And I'm also going to look for the PDS, the product disclosure statement. All ETF providers must include both of these with every ETF that they offer. So the product disclosure statement will tell you what type of strategy the fund manager is using whether it is passive or actively managed and it will go into much more detail as well.
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For instance, we can see that this ETF is passively managed and it tracks the performance of the index. The target market determination on the other hand will tell you whether or not the ETF is suitable for you and it will tell you in the target market summary.
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So in this case, it tells me that it's suitable for a consumer with a medium to long investment time frame of 5 years and it is very high risk. Okay, so that's the difference between an ETF and an index fund. I hope that made sense. I know it can get quite complicated.
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If you want more information, be sure to check out our best ETF page and our index fund guide. I'll leave links in the description below.
