Essentially an index fund (including Exchange Traded Funds) is simply a pool of money which tracks a predetermined index (which is just a basket of securities or assets).
For example an index fund might track the ASX200 which represents an index comprising the top 200 companies listed on the Australian Stock Exchange by market capitalisation.
But index funds ain’t index funds – they are many different structures that investors can use to invest in an index. Exchange Traded Funds or ETFs are really just an extension of an old idea – managed funds (open ended unlisted).
The diagram below shows the three main types of structure, exchange traded funds, managed funds and listed investment companies (strictly speaking listed investment companies are generally not index funds). The key point to takeaway is it is only an index fund if it follows an index! (not all ETF’s for example have to follow an index but most do)
Listed Investment Companies
Listed investment companies (LICS) are not technically index funds, in fact they are actively managed and their management fees are not generally as low as ETF’s (refer to LICS Listed on the ASX), they are also often leveraged (they have some borrowings) however since some of the listed investment companies in Australia offer similar diversified exposure to an index fund they have been included (refer to this article Understanding LICS)
Who cares about the index fund structure?
At one level whether you invest in a managed fund, an ETF or an LIC does not really matter to you, as long as your investment tracks the index, you gain the financial exposure you are looking for and your costs are low.
However the different index fund structures are well worth understanding as they do have some very important implications for the investor, taxation is one of them (refer to this article – Understanding Taxation)