DEFINITION of 'Index ETF'

Index ETFs are exchange-traded funds that seek to track a benchmark index like the S&P 500 as closely as possible. They are like index mutual funds, but where mutual fund shares can be redeemed at one price each day, the closing net asset value (NAV), index ETFs can be bought and sold throughout the day on a major exchange. With an index ETF, investors gain exposure to numerous securities in a single transaction.

Index ETFs can cover U.S. and foreign markets, specific sectors or different asset classes (i.e. small-caps, ADRs, etc.). Each asset incorporates a passive investment strategy, meaning the provider only changes the asset allocation when changes occur in the underlying index.

BREAKING DOWN 'Index ETF'

Index ETFs may occasionally trade at a slight premium or discount to the fund's NAV, but any differences will be quickly rubbed out through arbitrage by institutional investors. In most cases, even the intraday prices correlate to the actual value of the underlying securities. Other types of ETFs include leveraged  ETFs, which move like a regular ETF with an added multiplier, or short ETFs, which perform well when the underlying asset tumbles. Index ETFs are constructed from most of the major indexes such as the Dow Jones Industrial Average, the S&P 500 and the Russell 2000.

The fee structure is comparable to the cheapest no-load index mutual funds as measured by the expense ratio, but investors will typically pay standard commission rates for ETF trades. It is often charged when a buy or sell order is made, though many brokers offer a wide selection of commission-free ETFs. 

Index ETFs can be set up as either grantor trusts, unit investment trusts (UITs) or open-ended mutual funds, and will subsequently have some different regulatory guidelines. Most index ETF shares can be traded with limit orders, sold short and purchased on margin.

Advantages of an Index ETF

Like other exchange traded products, Index ETFs offers instant diversification in a tax efficient and cost effective investment. Other advantages of a broad-based index ETF include less volatility than a strategy specific fund, tighter bid-ask spreads (so orders are filled easily and efficiently), and attractive fee structures.

Of course, no investment comes without risk. Index ETFs don't always track the underlying asset perfectly and may vary as much as a percentage point at any given time. Investors should consider asset fees, liquidity, and tracking error among standard investing basics before making an investment.

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