Index funds are often touted as the perfect vehicle for following the market in a consistent, low-cost way. They are a fairly popular option among investors, especially thanks to the rise of robo advisors and 401Ks. But do index funds actually own stocks?
Index funds own stocks if the traditional indexing is adopted in the fund composition. Such funds track indexes, buying stocks in line with the weighting approach of the underlying index. In contrast, synthetic index funds do not own stocks. They track an underlying index using swaps and derivatives.
The rest of the article will cover how index funds work in more detail to help you understand why some of them own stocks while others don’t.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
How Are Index Funds Created?
There are two main approaches fund companies use when creating index funds: (1) traditional or physical indexing and (2) synthetic indexing. Let’s look at both of them in more detail:
Traditional or Physical Indexing
In traditional indexing, companies buy shares in the different companies in the specific index.
Every investor in the index fund becomes a shareholder in each of these companies, earning dividends where feasible. The size or number of shares owned comes down to how much you’ve invested in the fund, but your capital will be spread across multiple companies, offering the diversification these funds are known for.
For example, if you decide to invest $100,000 into a traditional index fund that tracks the S&P 500 today, your investment will be distributed across the 500 companies in the index at the time of your investment. Therefore, you’ll become a shareholder in each of these companies. The number of shares purchased (and money allocated) in each company comes down to the company’s weighting in the index.
Traditional index funds can track the underlying index and post similar returns by modifying the constituent securities in the fund as companies leave or enter the index.
These index funds own stocks because they actively buy shares from the companies in the index. As an investor, the stocks are technically yours on paper, but you can’t transfer them or decide to divest from specific stocks without completely exiting the index fund.
Advantages of Traditional Index Funds
- They are easier to understand. Everyone can understand that the fund tracks an index and will buy shares in the companies within the index. It’s a straightforward method of investing. Keeping an eye on the return curve of the specific index gives insight into how your investment is doing.
- You can enjoy dividend payouts. Since traditional index funds own stocks, you will receive dividend payouts from some stocks, increasing the overall return generated. However, this only works if the fund tracks an index with a healthy number of dividend-paying companies.
- There’s more transparency. You don’t need to be a finance engineering expert to understand how traditional index funds work. You can easily analyze everything from the composition to the historical performance of the fund.
Disadvantages of Traditional Index Funds
- There are more transactional costs. Traditional index funds have to keep tabs on movement within the index to rebalance the fund accordingly. The resulting cost from the rebalancing is passed on to investors. The costs are still below what you would get on a standard active fund, but they may eat into your profits.
- There is a risk of tracking errors. Think of tracking error as a divergence between the behavior of a position and the behavior of a benchmark. These errors may occur around rebalancing periods, leading to unexpected loss or profit on the position. In a loss, the index fund will post a slightly lower return than it should.
Synthetic Indexing
Synthetic indexing is a modern technique that relies on a combination of derivatives, equity index futures contracts, investments in low-risk bonds, and swaps to reproduce the performance of a specific index.
These funds are designed to replicate the return of an index like the traditional option, but they never hold the underlying assets. They use complex financial approaches to achieve the said results. If you invest in a fund that deploys synthetic indexing, you will not have any shares. Therefore, you cannot receive any dividends from the company.
Synthetic index funds that rely on swaps enter a deal with a counterparty—a bank in most cases. The bank’s end of the deal is a promise that the swap will return the value of the respective index the fund is tracking.
Let’s consider the same example from before:
When you invest $100,000 in a synthetic index, your money goes into the fund company’s complex financial approaches instead of towards purchasing any shares. Still, they will return a performance that mirrors the index the fund is tracking by the end of the year.
Advantages of Synthetic Index Funds
- The fees are lower. Synthetic index funds generally have a lower expense ratio. The funds do not have to worry about portfolio rebalancing, which makes them more passive investments overall. The reduced administrative bottlenecks are passed on to investors as lower fees.
- There are lower tracking errors. There is no risk of tracking errors since synthetic index funds do not have to deal with rebalancing. The funds mirror the underlying index very closely overall.
- They offer more opportunities. While traditional index funds are limited to tracking highly liquid underlying index funds, synthetic index funds can offer access to less liquid benchmarks and remote markets worldwide.
Disadvantages of the Synthetic Index Funds
- There are no dividend payouts. Synthetic index funds don’t buy the underlying securities, so you won’t receive dividend payouts from various companies. The loss of dividend premiums may lead to slightly worse performance when compared to traditional index funds tracking the same index (assuming the index is one that features lots of dividend-paying companies like the S&P 500 or Nasdaq-100).
- There is counterparty risk. As we mentioned above, the return on a synthetic index fund is dependent on the counterparty honoring the contract. Therefore, investors are exposed to counterparty risk. Most fund companies (and the regulatory bodies) have put mechanisms in place to mitigate the risk, but it’s still there for investors to worry about.
Which Is Better: Traditional Index Funds vs. Synthetic Index Funds
You should go with an option that agrees with your wider investment strategy instead of choosing one because it owns—or does not own—stocks.
Although traditional index funds own stocks and allow you to earn dividends, rebalancing and the slightly higher expense ratios can eat into your return. On the other hand, synthetic index funds have very low expense ratios, but they do not own stocks and thus cannot pay dividends.
The counterparty risk, which can be limited by collateralizing, is a possible source of concern as well.
Speak to your financial advisor if you are unsure of what approach to follow. They will analyze your overall investment strategy and advise which side of the divide to lean towards.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
Index funds based on the traditional indexing approach can own stocks, but synthetic variants cannot. Keep in mind that the stocks bought through an index fund are not transferable. You only own the stocks and qualify for dividends as long as you stay invested in the fund.
Synthetic index funds do not own stocks, but they may still prove to be the better investment vehicle to go with for your overall portfolio. Remember, they can give you access to investment vehicles that may be too difficult or too costly to replicate with traditional indexing.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
Recent Posts
Exploring Social Trading: Community, Profit, and Collaboration
Have you ever wondered about the potential of social trading? Well, that curiosity led me on a fascinating journey of surveying over 1500 traders. The aim? To understand if being part of a trading...
Ah, wine investment! A tantalizing topic that piques the curiosity of many. A complex, yet alluring world where passions and profits intertwine. But, is it a good idea? In this article, we'll uncork...