Q: I'm a young investor looking for opportunities, and was wondering: what's the difference between ETFs and index funds? Are they the same thing?
A: The investment industry has begun launching new Exchange-Traded Funds, or ETFs, in large numbers, and anytime Wall Street is that enthusiastic about a product, the investing public should proceed with caution.
Naturally, there is more to a well-rounded investment program than just savings accounts. Stocks can bring an element of growth and inflation protection to a portfolio, and with CDs, savings, and money market rates near zero, people are eager for more promising alternatives. ETFs can be a convenient way to get into the stock market.
Although ETFs are often associated with index funds, which seek to replicate the performance of a group of stocks representative of a specific market or market segment, ETFs may also seek to add value through stock selection without being bound to representing specific market characteristics.
So, the first thing an investor needs to decide is whether the goal is to capture the performance of a specific group of stocks, or to try to pick a manager who can add value via stock selection. Then, there are three key things to look for in an ETF:
- Tracking error. If you are trying to capture a specific market segment, you need to know an ETF's tracking error - the extent to which it has deviated from the performance of that segment in the past.
- Fees. Compare fees on the underlying funds. Index funds which don't seek to add value should have very low fees.
- Track record. Look at past results over the course of a market cycle, which is a full range of rising and falling conditions.
Finally, don't pile into an investment just because it is hot at the moment. Understand the role you want each investment to play - and the risk it represents.
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