A tracker or index fund is an investment fund of which the strategy is to replicate or “track” the performance of a financial index. It differs from traditional investment funds in its passive approach that drastically reduces costs and avoids investment managers’ mistakes. Most trackers can be bought on a stock exchange all day long. These are referred to as Exchange Traded Funds or ETFs.
An ETF is primarily an investment fund like any other, thus a financial product that pools the money of several investors to build a diversified portfolio of securities. These securities may be stocks, bonds or other financial products. Like all funds, the ETF is subject to investment rules and strict control by financial regulators.
However, ETFs differ from other funds in the way their investment portfolio is set up and managed. If the composition of a traditional fund is defined by a manager and changes over time according to his convictions, that of an ETF is known in advance and determined based on the composition of a financial index. Since the composition of an index changes periodically, the portfolio of an ETF is not static and evolves as well over time.
An ETF allows an investor to get easily exposed to a diversified portfolio of securities that he would have a hard time building alone. Thus, by means of a single ETF worth only € 100, an investor can now expose himself to the 9.000 shares, 47 countries and 11 sectors that make up the MSCI World ACWI IM index, where it would take at least 1.000.000€ to buy one share of each company making up this index. Through such diversification an investor avoids the high risk related to direct exposure to single stocks, and thus limit the risk of maximum loss of his portfolio.
The primary objective of an ETF is to return to its investors the performance of the index it tracks. There is therefore no surprise, good or bad, as to the performance of the tracker compared to its reference market, unlike with fund actively managed. Indeed, if the benchmark has gained 10% over a given period, the ETF's performance will also be close to 10%. Some factors such as daily liquidity and fees can, however, make it slightly deviate.
A major advantage of ETFs over traditional funds is their reduced fee structure. While an investment fund costs on average 1,9% in Belgium, the costs of an ETF are typically 0,3%, or 6 times lower. They vary between 0,08% for the most common ETFs (e.i. S & P 500) and 0,65% for the most exotic ones (e.i. emerging countries). Thanks to compound interest, this fee reduction has a significant positive impact on long-term returns.
Most ETFs differ also by the fact that they can be bought and sold on a stock exchange. The buying or selling price is therefore known at the time of the transaction. This is not the case for orders on traditional funds that are only accepted once a day and get formally executed the next day at a price yet to be determined.
Trackers can be of two natures: distribution or capitalization. A distribution ETF periodically pays the interest and dividends it receives. The capitalization ETF automatically reinvests its income within the fund. This capitalized income generates more profit, which the investor recovers as a capital gain once the ETF is sold. easyvest favors capitalization ETFs that minimize reinvestment costs and tax impact.
Although trackers really began to gain momentum in Europe after the financial crisis of 2008, they have been around since the 70s. The first tracker, the Vanguard 500 Index Fund, was indeed launched in 1976 by Jack Bogle, the founding father of index management. Across the Atlantic, this type of investment instrument has boomed since the 90s to dominate today the US investment fund market with companies like such as State Street, Vanguard and Black Rock that have become the 3 largest asset managers.
Over the last 15 years, Warren Buffett, the best investor in the world, has not been able to outperform his reference index, the S&P 500. Having fought all his life to reduce investment costs and optimize taxes, two key advantages provided by index funds, he could only fall in love with ETFs. This is undoubtedly why he openly recommends them to investors and why he has given as instruction that after he passes away, his fortune be invested passively in ETFs.
ETFs have multiplied so much in recent years that there are now more than 7.000 around the world. This astronomical number makes their selection difficult, as the criteria to consider are manifold: index, dividend, capitalization, costs, geography, sector, taxation, issuer. In this perspective, it is better to rely on the recommendations of an expert like Easyvest to build a balanced and performant portfolio.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.