What are index ETFs?

Definition

The majority of ETFs aim to mimic the results of an index. Therefore, having knowledge about the process of creating and managing those indexes is crucial when selecting the appropriate ETF to invest in.

Types of indexes

There are two primary categories of indexes: those that monitor the entire market, such as the S&P 500 Index, and those that track a narrower subset of the market, such as large-cap value stocks or small-cap growth stocks. Additionally, there are indexes for commodities, currencies, and bonds. Index-based ETFs aim to achieve the market or subset's return, minus fees, but they may not perfectly match the underlying index, resulting in tracking error. Typically, investors compare more focused indexes to broader market indexes to make investment decisions.

Index construction

Indexes are created to accurately measure the value of a specific financial market or segment of that market. They are stable collections of stocks, bonds, commodities, or other assets that serve as standard measurements worldwide for overall price level, risk, and return. Indexes represent the full range of investment opportunities that are available to all investors in the marketplace. Every index can be easily replicated by an investor using the rules established by the index provider.

Equity indexes typically select and weight securities passively based on their market capitalization. Index providers usually include a wide variety of securities and strive to minimize the turnover of those securities. Some indexes include all publicly available securities, while others use a representative sample of those securities.

Many popular market indexes do not include all securities in the broad market, but they do hold enough securities to qualify as a market index. Sampling methods can be optimized to closely track the broad market. For example, the S&P 500 Index does not hold all large-cap stocks, but it holds enough securities to closely reflect the risk and return characteristics of a broad basket of large-cap stocks.

Indexes select securities from all securities exchanges, including the NYSE and NASDAQ. Equity indexes are capitalization-weighted, meaning that each stock in the index is weighted proportionally to its market value relative to all other companies in the index. Larger companies have a greater impact on index performance than smaller companies.

There are different types of capitalization-weighted indexes, including full-cap, free-float, capped, and liquidity. Free-float indexes only include securities available to individual investors, while full-cap indexes include all securities outstanding. Liquidity indexes weight stocks based on the amount of shares that trade regularly, which is particularly useful in emerging markets where a sizable number of outstanding shares may have limited liquidity.

Why should I consider an index ETF?

There is a belief, supported by extensive research, that suggests individual investors should invest in low-cost market indices and adjust their allocation between stocks, bonds, and other assets based on their age and changing risk/reward profiles. If you agree with this approach, index-based ETFs can be beneficial.

These ETFs offer advantages such as lower volatility than industry-specific and strategy-specific ETFs, tight bid-ask spreads, and lower costs due to minimal portfolio turnover and research costs. However, like all investments, index ETFs come with risks. Investors are tied to the performance of the underlying index, and not all ETFs that track the same index perform equally. Therefore, investors should consider factors such as fees, liquidity, and tracking error before choosing an index ETF.