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.
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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.
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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.
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