Index-based exchange traded funds are an easy-to-use investment vehicle that provides investors exposure to diversified and targeted markets around the globe.
Most ETFs on the market passively follow the performance of an underlying index or benchmark, typically providing investors with broad exposure to a large portfolio of stocks or securities at a very low price, writes Sheyna Steiner for Bankrate.
An index is the broad representation of a set of companies in a particular market segment or entire market. For instance, the most popularly observed indices in the U.S. include the Standard & Poor’s 500 index, the Nasdaq Composite and the Dow Jones Industrial Average.
There are broader and narrower indices that investors can focus on. The Wilshire 5000 is a broader index that measures the performance of all stocks actively traded in the U.S. In contrast, the Russell 2000 index is a popular measure of small-capitalization stocks.
“A good way to think about it is like a funnel,” Jim Rowley, senior investment analyst at Vanguard, said in the article. “You could think about it in terms of the broadest of the broad markets and then imagine it narrowing to focus on specific types of companies.”
For example, among the broadest of the broad markets, the Vanguard Total World Stock ETF (NYSEArca: VT) follows the FTSE Global All Cap Index, which is a weighted index of large-, mid-, and small-cap companies across industries in almost all equity markets around the world, including both developed and emerging markets. Through this one ETF, investors can track a group of 7,104 international stocks.
On the other hand, investors can also choose more targeted single funds that track individual countries, regions or markets. Moreover, people can customize portfolios further with ETFs that focus on asset categories, like large-, medium- or small-caps, and specific sectors, such as the tech or health care markets.
Moreover, bond index-based ETFs also divvy up the fixed-income markets in similar ways. However, bond ETFs may categorize markets by credit-quality and maturity.
Unlike traditional open-end mutual funds, index-based ETFs can be traded throughout the day on a brokerage account, similar to company stocks. Additionally, index ETFs are distinct from actively managed funds as index funds only passively mirror a benchmark, whereas active managers may pick and choose component holdings to beat the market. However, index funds have consistently outperformed the more costly active funds over the years. [Passive ETFs are Looking Even Better Next to Active Funds]
Investors who are interested in crafting an investment portfolio should consider a group of low-cost index-based funds. For instance, one can create a diversified portfolio with just a few investments, including a broad U.S. market index fund, international market fund and investment-grade bonds. [Build a Diversified Investment Portfolio with Just Three ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.