A passive management strategy for an exchange traded fund (ETF) will typically include an index, but what exactly is inside an index, and what makes it more beneficial than a mutual fund?
An index is a collection of assets that can serve as a benchmark to track the performance of that particular market. The S&P 500, for example, is a collection of the 500 largest companies, and its performance can broadly imply how the overall stock market is doing.
The performance of an index is almost like a medical checkup — doctors will look at various aspects of someone’s health (heart rate, blood work, etc.) and take note of their findings. This assessment will give an overall picture of a patient’s health. Similarly, the performance of the index is like a health assessment of the market.
What an index ETF will do is exactly as its name states: It tries to mirror the performance of the index. It’s almost like a high stakes game of follow the leader — ETF providers will construct the holdings of the fund to follow that particular index.
This will also reflect in the product description of the ETF. For example, in the SPDR S&P 500 ETF Trust (SPY ), the product description says that it “seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index.”
As mentioned, the index is a collection of assets. So in addition to stocks, index ETFs can track indexes comprised of bonds, commodities, and other asset classes.
The Advantage of Index ETFs
ETFs that track an index offer certain advantages over other types of funds, namely a mutual fund. Because shares of an ETF can be purchased and sold during market hours on an exchange, they offer more flexibility than mutual funds. (Shares of these funds are traded once per day.)
This opens ETFs up to day traders who need to get in and out of a position quickly. The intraday trading ability of an ETF allows traders to use them in order to extract profits in the short term, which is a different strategy than that of a buy-and-hold investor.
Portfolio managers can also benefit from this flexibility. They can adjust a portfolio of index ETFs as necessary when market conditions warrant a change.
For example, if there’s a broad sell-off in the technology industry, a portfolio manager can minimize exposure to a tech ETF and add more exposure to a safe haven asset like a bond ETF. This on-the-fly adjustment feature speaks to the flexibility of index ETFs and ETFs as a whole.
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