Index Funds & Exchange Traded Funds

Index funds mechanically buy stocks in direct proportion to the stock’s value in the stock market, and they therefore mirror the market’s performance. They own a bit of everything, and therefore provide average returns. Historically the market has done well, so even average returns have been good.

Index funds charge low fees because they don’t employ investment managers and analysts to value stocks.

A single index fund will diversify you across the whole Australian stock market. Similarly you can cover the whole US market with a single index fund, and likewise for other country markets.

However, index funds have drawbacks. Because index funds just buy blindly and do not value stocks, you can get caught if you buy them in an overvalued bull market.

Again, because indexed funds blindly buy the whole market, they buy the “good, the bad, and the ugly.” That is, underpriced, mediocre and overpriced stocks. This already happens with many overpriced tech stocks.

Exchange Traded Funds (ETFs)

An ETF is an index fund that trades on the stock exchange. Its advantage is that it is easy to buy and sell on the market. However, because of their popularity and huge size, ETFs are adding to the increased volitality seen on stock markets.

ETF trading triggers capital gain tax on their underlying portfolio. ETF investors not selling are caught paying these capital gains taxes.

EFT can leverage using synthetics and derivatives, adding to their risk.

ETFs have the potential to cause a major stock market rout, echoing the portfolio insurance debacle of the 1987 stock market crash, or the sub-prime blunder responsible for the 2008 global financial crisis.