An index fund is a type of investment fund which aims to replicate a market index. Rather than actively buying and selling assets like actively-managed mutual funds do, index funds simply buy the stocks or other assets which an index follows.
An index fund which tracks the Swiss Market Index (SMI) will try to match the SMI’s performance as closely as possible.
An index shows the current market value of one or more stocks, bonds, or other assets. For example, the SMI shows the weighted average prices of the 20 most significant stocks on the SIX Swiss Exchange.
A fund can copy an index by investing in the asset(s) which the index tracks. Because very few transactions are required, these passively-managed funds require very little work from fund managers. For this reason, they are often much cheaper than actively-managed funds.
Index funds vs. ETFs
Both index funds and exchange-traded funds (ETFs) aim to replicate the performance of an underlying index. Both types of funds are generally passively managed, and often have much lower costs than actively-managed mutual funds.
The main difference between index funds and ETFs is that an ETF is listed on a stock exchange, while an index fund is not. Shares in ETFs can be bought and sold right throughout the trading day. Shares in index funds are bought from and sold back to the index fund, and this can only be done once a day.
This means ETFs offer more flexibility to traders, allowing them to take advantage of intra-day price fluctuations. For long-term investors, however, this difference is of little significance. ETFs have the added advantage that investors can find and trade them easily using affordable online trading platforms.
Index funds, on the other hand, are generally offered directly by fund managers or banks. The process of buying and selling shares in index funds can require somewhat more effort. Some online trading platforms do give you access to certain index funds, but availability varies broadly between platforms.
Another important difference between index funds and ETFs is that index funds are generally physical, meaning they invest directly in the actual assets which underlie an index. ETFs, on the other hand, may be physical or synthetic. A synthetic fund uses swaps and other derivatives rather than investing in real assets, which exposes them to counterparty risk. The advantage of synthetic replication is that it allows you to invest in certain indexes which cannot be replicated by physical funds (certain commodity indexes, for example).
There are also tax differences between index funds and ETFs. Swiss index funds are not subject to Swiss stamp duties, but Swiss ETFs are. When you invest in foreign index funds using a Swiss stock broker, the Swiss stamp duty applies when you buy shares in the fund, but not when you sell them. For foreign ETFs, on the other hand, you pay the stamp duty both when you buy and when you sell your shares.
Depending on where the fund is domiciled, and where the companies it invests in are domiciled, there may also be differences in withholding taxes. This depends on the specific double taxation agreements (DTAs) of both countries. Example: An ETF domiciled in Ireland pays half as much withholding tax on US dividends as an Irish index fund. That is because the DTA between Ireland and the US lets ETFs reclaim half the withholding tax, but does not extend this privilege to index funds. This can have a significant effect on fund performance, particularly for funds which focus on dividend stocks.
Points to consider when investing in index funds
As with other funds, the annual total expense ratio (TER) of an index fund is an important factor. Index funds simply replicate an index. If there is a different index fund or ETF which tracks the same index but has lower costs, it generally makes sense to use the most affordable option. However, the location, creditworthiness and size of the fund are also factors to consider.
It is also worth looking into whether or not an index fund makes use of securities lending. Funds which make use of securities lending are exposed to counterparty risk, whereas those which do not have no counterparty risk.
Withholding taxes are also an important consideration. The Swiss withholding tax on dividends can be reclaimed for index funds (and ETFs) which are domiciled in Switzerland and hold Swiss assets.
Index funds allow you to invest broadly in one asset class, such as shares or bonds. However, if you want to invest in different asset classes with a single fund, this is generally not possible with index funds. In most cases, a combination of index funds is needed for proper diversification.
More on this topic:
How to choose the right investment fund
Passively managed funds vs. actively managed funds
Compare Swiss online trading platforms now
Swiss fund savings plans explained
Swiss investment fund accounts explained
Strategy funds explained
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