The passive investment world can be rather confusing to the inexperienced investor. You have passive tracker funds and exchange-traded funds (ETFs), both track a benchmark, and both are expected to give you performance which mirrors that of the benchmark it tracks. They work because they allow you to build low-cost, diversified portfolios. But what’s the difference?
Most index funds are set up as either open-ended investment companies (OEICs) or Unit Trusts (the UK equivalent of a mutual fund). These are known as open-ended because the supply of shares is not restricted, new shares can be created to meet the demand from buyers, or shares can be reduced to meet the obligations of the sellers. ETFs on the other hand trade on the stock exchange like any other share.
The price of both tracker funds and ETFs mirror that of the benchmark it tracks. That means if the value of the assets that make up that benchmark drop, so will the price of the tracker or ETF. However, you don’t usually know the price of the index fund before you buy it, this sounds strange and is known as forward pricing, you will pay the price at the funds next valuation, this happens at a set time each working day. The price of an ETF is subject to change throughout the day, like a normal stock, and you will know the price of the ETF before you buy or sell.
Choice in the index fund world can seem rather limited, in terms of both asset class and providers. There are entire asset classes which don’t have any index funds, and even when the index funds exist, there’s only a handful of suppliers. ETFs on the other hand almost have too much choice, there are ETFs for large, diverse markets, and even for specific industries. It’s important to understand what you invest in, or to take advice from professionals.