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An index exchange-traded fund (ETF) is a type of investment that attempts to track the performance of a market index. An Index ETF is traded on an exchange like a stock, and can consist of different securities. It is similar to an index mutual fund, but often offers lower expense and tax consequences. Index ETFs are not actively managed, can track many different indexes, and may use different methodologies to track their respective indexes.
The first Index ETFs appeared in the U.S. in 1993, and quickly became popular because of their flexibility, convenience, and simplicity. These funds are made up of smaller pieces of other securities, such as stocks or bonds. An Index ETF that tracks the S&P 500®, for example, might have holdings in all the corporations that make up the S&P 500® index. ETFs that track other indexes may consist of other types of assets. A bond index ETF might contain several different municipal or corporate bonds, while an ETF that tracks commodity indexes could consist of futures contracts or the underlying commodity itself.
It’s common for an index ETF to be compared to an index mutual fund. In many ways, the two are quite similar as they both seek to track an index as accurately as possible. Both can offer investors a relatively easy way to diversify their portfolio, and both usually use a predefined strategy rather than active management to track their respective index. Neither attempts to beat the index, only to replicate its returns.
ETFs tend to have a few advantages over mutual funds when it comes to expenses and fees, though these can be relatively minor depending on the individual funds. Mutual funds tend to have higher management fees and expense ratios than ETFs. In the U.S., ETFs often have a tax advantage over mutual funds. On the other hand, mutual funds don’t usually have transaction fees when purchased directly from the management company, while ETFs are subject to broker’s commission fees.
The lack of active management means that an index ETF uses rules or strategies to track its index. These rules can vary depending on the fund, so different ETFs that track the same index might have different portfolios. Some funds heavily weight a specific sector of their index. Newer “smart” index ETFs use dynamic portfolios based on valuation to attempt to outperform the market.
Index ETFs are available for virtually every market index. Many international ETFs track foreign indexes to give investors global market exposure. Commodity ETFs can track the price of common commodities like gold. Index ETFs can also track narrow segments of the market, such as biotechnology or even the price of corn.