Stock index investing

Investing in stock indexes

How to buy a stock index?

Not so long ago, the investment in the stock exchange index may have been associated either with transactions on futures contracts or with the purchase of stocks included in the index, which exposing the investor to significant transaction costs.

ETFs have given a new possibility to invest in the index.

Stock index investing: what exactly is ETF and what distinguishes it from other investment opportunities?

Exchange Traded Fund (ETFs), being spot market instruments, are open-ended index funds listed on an exchange. The purpose of such a fund is to faithfully reproduce a given stock, commodity, bond or money market index.

Characteristic feature of this instrument is the possibility of constant creation and redemption of participation units, as well as the high liquidity provided by market makers and low transaction costs in comparison with independent buying of stocks on which a given ETF index is based. From the investor's point of view, ETF is a convenient instrument that allows investing in a specific benchmark.

The first ETFs were listed on the Toronto Stock Exchange in Canada at the end of the 1980s. Then they started to appear in the United States and Hong Kong. The first ETFs were listed in Europe in 2000. Over the following years, the popularity of these instruments increased significantly, which was reflected in growing trading volume on the stock exchanges. Currently, the capitalization of this type of instruments is approaching the level of one and a half trillion dollars.

Stock index investing: who can invest in ETFs?

Both institutional and individual investors can invest in ETFs. They are among the interests of insurance companies, pension funds and all types of Asset Management institutions offering Private Banking services.

Stock index investing: comparison of ETFs with other financial market instruments.

Differences and similarities between futures contracts and ETFs

Although ETFs may at first glance resemble futures contracts, there are significant differences between them. ETFs are spot market instruments and reflect the present value of the underlying, while forward contracts in theory refer to future underlying values. Another difference is connected with the financial leverage, which is present in the case of futures contracts and causes increased investment risk.

ETFs are not truncated, so small fluctuations will not cause high profits or losses. A further difference between the two instruments is related to the absence of a margin deposit for ETFs and the possibility to participate in the payment of dividends of the companies in the index on which the ETF is based.

 On the other hand, the similarities between these instruments include the possibility of playing both increases and decreases.

ETFs and open ended investment funds

Open ended investment funds usually give the possibility to play only for increases (with some exceptions, there is no possibility to earn money on inheritances). There are also significant differences in the level of fees for managing ETFs and open end funds.

In the case of ETFs, only a management fee of up to 1% per year is charged, whereas in the case of open ended funds, the management fee is often up to 5% (e. g. for very aggressive equity funds). In the case of ETFs there are no entry and exit fees (the only cost to the investor is the spread amount), which are an integral part of open-end funds (e. g. in case of redemption of units).

Stock index investing: risks related to investing in ETFs

The risks associated with investing in ETFs depend on the direction in which the market moves. It also depends on the amount of capital involved. Diversification of the portfolio related to investing in an index-linked fund of the ETF type distributes transactional risk as compared to a single purchase of stocks, which apart from higher transaction costs cause additional difficulties in controlling all the assets at the same time.