The virtues of Index Funds and ETFs have been well covered by experts, making it an indispensable investment product.
For this reason, a growing number of index and exchange-traded funds have been made available.
Which makes it difficult to select an adequate fund.
Before I go over the distinctions comprised across Index Funds and ETFs, we need to agree on the thought process behind investing in index funds.
When you invest in an Index Fund it’s because you believe in the strong version of the EMH.
In other words you think it’s impossible to win the game of beating the market so you want to replicate it as closely as possible.
This being the case, your goal and only goal should be to replicate the index.
Distinctions concerning Indexes and ETFs
Besides their cost, a distinction between the funds is the way in which they are designed and managed.
Here is a list of different ways ETFs can be formed:
– A concentrated strategy aims to overweight certain market sectors more than others
– A Speculative strategy, for example, bets on the success of IPOs or micro-cap stocks
– An Inverse ETF is constructed to profit from the decline of the stock market instead of always following its direction.
– A Leveraged ETF borrows money to invest in order to increase the return
– A factor / smart-beta allocation is based on elements that affect the risk-return relationship of an investment, such as value, size, momentum, etc.
We can see that a lot of those ETFs have gone astray of the objective of a passive investment strategy to more active management.
Some of them trying to perform better than the index while their goal should be to simply replicate it.
To have an efficient portfolio you should select an index fund or ETF that has the lowest cost, established by a market capitalization-weighted strategy, and has the lowest tracking difference.
Why a market capitalization-weighted strategy?
Well, that’s because the S&P 500 is a capitalization-weighted index. If you want to copy something, shouldn’t you copy it as closely as possible?
The moral of the story is pick a traditional index fund. There is less work to be done for choosing one.