The index tracking fund and the ETF

What do index tracking fund and ETF mean?

For money invested in mutual funds to grow, it has to be managed somehow. This can be done actively or passively. The index-tracking fund and the ETF implement passive asset management.

With active money management, a portfolio manager decides when and where to put your money. For passively managed funds the fund copies an index, and the composition of the fund is automatically adjusted to the composition of this pre-assigned index. This is why passively managed funds are called index tracking funds.

What is an index?

The index is a representative sample of (usually) the stock market to quickly measure stock market performance.

When you team up with your friends, weigh your weights, add and average, you get your weight index for that measurement time. If you do this at regular intervals, you can see the change in your weight index. After a Christmas eat-and-drink period, it will obviously increase, after a survival camp it is likely to decrease.

If I cook lunch and want to distribute the food based on the weight index, the biggest person gets the most, the smallest the least.

What is index tracking?

The compilation of indexes work in the same way in the financial world. It is based on the shares of companies selected by professionals, they look at how each performs. The securities of a company in a period of prosperity, which is just abundant, are obviously doing well, while the share price of a company that is in a tighter period will adjust accordingly.

The index-tracking investment fund as well as the ETF copy these weights. If a company performs better based on that index, it buys more of it, and if it starts to decline, it sells.

If you choose a fund that has selected the Hungarian BUX as the index to be copied in its operating rules, this division will be used as the basis for the selection. It will obviously not buy all of them, but it will only add them to your portfolio from these selection and only to a pre-determined extent.

Which is better, actively managed or passively managed mutual fund?

There is no clear answer to this question, after all, if one were far far better than the other, there would be only one.

Both have their pros and cons, and it’s up to you which one you find more sympathetic (or just accessible).

What determines the performance of the index tracking fund and the ETF?

Index tracking funds and ETFs (Exchange Traded Funds) track the performance of the market average. Although there is no person behind them who would actively make a decision, their returns can still be outstanding. Indeed, indexes are not created by themselves, the professionals who compile them do a very careful job. They also do this because their corporate reputation depends on their attitude.

The performance of the fund depends on which index the management policy designates and which part of it is copied. Accordingly, the performance of two index-tracking funds may differ even if they follow the same index.

What do the index fund and the ETF invest in?

Both an index tracking fund and an ETF can invest in a large number of exchange traded products and securities. It can be a bond, it can be a stock, but it can also be any crop or anything else (e.g. coffee, precious metal).

According to the direction of investment it can be:

• Currency ETF
• Industry ETF: As the management rules can specify which securities from the selected index will be included in the basket, the fund’s creators can also choose within a given industry.
• Commodity ETF: (this is more of an ETN or ETC) is similar to an industry ETF in that it focuses on certain segments of the market. However, using a commodity ETF does not actually take ownership of that product (such as oil or coffee). They emulate the price through derivative transactions
• Bond ETFs: Because bonds are generally held to maturity (but at least till interest payment), their liquidity is lower. This is why it is relatively difficult to create a bond ETF, but not impossible. It operates in sufficiently large markets.
• Equity ETFs: This is how a “simple” index tracking fund works, this is the most common form.

Because they are copying a stock index, assets that you cannot obtain in this way cannot be included in the portfolio. For example, bank deposits are omitted.

Note:

As you can see, bonds and stocks are also available in ETF form. They invest in a similar area as traditional bond funds and equity funds, only their way of money management differs.

How does an index tracking fund differ from an ETF

Although both operate in the same direction, ETFs, like other exchange-traded assets, can change hands several times a day.

What to look out for when investing in an index tracking fund or ETF?

Investment period

In this respect, the same applies as for the recommended term of mutual funds. The fund manager shall specify in the fund description the recommended time horizon according to the risk level of the investment fund. If you don’t have that much time to reach your financial goal, then that fund may not be right for you. Although you can sell an ETF unit at any time, be aware that there is a risk of a loss within the recommended timeframe.

Investment strategy

How actively do you want to trade ETF units? There is also no problem with “sitting on it”, i.e. buying and selling later (Buy and Hold strategy). It’s also perfectly okay if you decide that, like individual securities, you want to realize the results you achieve at regular intervals, so you sell and buy something else instead.

The problem starts there when you use the two investment strategies together and just “pull” it all, or you just make a decision based on your emotions (i.e. you sell out of panic or fear and possibly buy out of greed).

Select risk level

To do this, you need to know how risk-seeker / risk-averse you are and what your time frame is. The longer the time available to you, the more confident you can choose. Do this if there is help behind you (from the fact that an investment is risky, it may not always have a high yield) and you are at least able to bear the risk yourself.

We can help you choose the right investment direction for you, here you can contact us.

The fund’s performance to date

It’s not a good thing to choose an investment device based solely on past performance, because then you can easily get into a situation where you buy at the top of the highs you’ve achieved so far, before it falls. Apart from this, you still need to know how the investment fund you like so far performs compared to the others.

Taxation

The fund manager may also pay you dividends on the underlying shares (in which case you may have a PIT obligation according to the regulations of your country) or include them in the price of the fund. If they incorporate it, you typically only need to pay attention to the tax, if you are trading the unit on your own (and gained some profit). Through an insurance company or a solution built into banking products, this financial institution will arrange this for you.

Investment direction

There are real assets behind both the index tracking fund and the ETF. The performance of these underlying assets, and thus of the investment fund, depends on which area (whether geographical or economic) it focuses on. Before investing in anything, review it carefully to be aware of the expected outcome.

Benefits of an index fund and an ETF

Cheap

The index tracking fund works for pennies compared to the actively managed fund. The portfolio manager also asks for 1-2% per annum for his work (this can be a much higher value). This means for you that they charge HUF 10-20,000 per year as a handling fee for every 1 million forints they manage. Although fund managers employ the best trained professionals, they have no influence on market processes. This fee will be deducted from you even if there is no way to extract it.

The cost of an index-tracking fund or ETF is around HUF 2,000 per year for the same amount.

Transparent

Both the index tracking fund and the ETF provide you with the names and weights of the companies that make up the fund.

Liquid

As with any mutual fund, you can monetize your investment at any time. Note that while you may, you don’t have to do this. The price of the unit may change, so a poorly chosen sale date may result in a loss to you.

Comfortable

By using these funds, you become the owner of multiple shares at the touch of a button. Although the operation of an ETF is completely transparent, you can always see when how much of what it contains, so you could buy the underlying assets yourself one by one, but it would take a lot of time and energy. Not to mention the transaction costs, so if purchased separately, you might get the same much more expensive.

Disadvantages of the index fund and the ETF

Buys overvalued papers

Copying indexes also means that the fund outweighs the securities that perform well. This is fine within healthy limits, but no one can stop it from copying so that an overvalued stock is not included in your portfolio.

There can be two ends to this: either everyone is very surprised by the company’s performance of being able to shoot out of even an overrated situation (this is rarer), or it is the end of a big brawl when the balloons burst.

Skips undervalued papers

Although undervalued securities, ie securities with high yield prospects due to their low exchange rate, will be included, but their weight will not reach a reasonable level. As the market temporarily sees no value in them, they are also given less weight in the index copied by the fund.

Skips growth phase

Managing an actively managed fund allows the portfolio manager to make decisions about new directions within its capabilities. It is advisable to buy into a company that is still small but has a big future at the beginning, so that the investor can make a big profit later.

A good example of this is Amazon.

It went public on May 15, 1997, and for many years its price only occasionally exceeded $ 20. It currently stands at 3,340. If you look at the graph, you can see that right at the very beginning, the ETF would have said no to Amazon stocks.

Index tracking fund and ETF risk

The risk listed for mutual funds can, of course, also affect index-tracking funds and ETFs, as we are also talking about mutual funds.

In addition, the fund manager provides some risk indicators as well as a benchmark (know what you need to compare to.

We don’t run through the “standard risks” now, instead we look at what the risks specified by the fund manager mean.

Standard deviation

Exchange rate changes. Shows the volatility of the asset fund. The higher this value, the greater the rate of exchange rate change, the smaller, the more stable the exchange rate.

In general, higher standard deviation means higher risk and thus higher expected return.

Sharpe

It shows how much risk has been achieved by taking extra returns above risk-free returns.

The risk-free return can be e.g. the yield on a discount treasury bill, its rate and the yield achieved also change from time to time. Calculation: The excess yield is divided by the standard deviation.

The higher its value, the higher the return per unit risk level. If the value of the indicator is negative, the increase in value falls short of the risk-free level.

Tracking error

It shows how much the fund’s return has deviated from the benchmark over time.

Information quotient

The ratio of the excess yield achieved to the deviation from the reference index.

Beta

Shows the level of risk relative to the benchmark.

A value greater than 1 indicates that it has a higher volatility (the above-mentioned standard deviation, and thus its risk) compared to the reference index.

A value of less than 1 occurs when the risk profile is lower than the reference index.

Alpha

An indicator of the fund’s performance relative to the benchmark, taking into account the risk taken.

If the value is positive, the fund manager has exceeded the return achievable by the benchmark, if it is negative, this has not been the case.

Maximum relapse

It shows the largest decline in the value of the fund during the period.

Summary

By using index tracking funds and ETFs, you have the opportunity to build a well-diversified portfolio cheaply and conveniently according to your own financial goals and level of risk-taking.

As with any investment, keep in mind that returns and levels of risk go hand in hand, so before you decide on anything, be properly informed. If you ask, we can help you with this, you can contact us here.