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Unless you've been living under a rock, you've probably noticed the explosion of index investing and exchange-traded funds.

The problem is, most people equate them to be one and the same. They are not.

The confusion is analogous to "buying RRSPs," a friend pointed out. You don't buy an RRSP. Rather, an RRSP is a special type of investment account that holds investments you purchase.

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You can think of ETFs and mutual funds in a similar vein. Many people assume that if you are an index investor, you must use ETFs. Or vice versa, they will assume you mean index investing when you mention ETFs. Both of these assumptions are incorrect. The ETF and the mutual fund unit trust are just structures within which various securities can be placed. Either can replicate an index and be actively managed.

The US ETF industry recently passed $1-trillion in assets invested. This has been due to passively managed ETFs, which track indexes and require no active investment selection, but industry pundits are suggesting that the next main growth phase will be in actively managed ETFs, helmed by a manager making active investment decisions on an ongoing basis. Actively managed ETFs are alive and well in Canada as well.

With respect to mutual funds, there are thousands available in Canada, and there's essentially a fund available for every basic investment mandate.That includes index strategies, although most mutual funds are actively managed.

To add to the confusion, an ETF can qualify as a mutual fund. Just take a look at the most recent iShares prospectus and you'll find it referenced in a few places. Under the heading "Status of the iShares Funds," I found the following quote: "Counsel is advised that each of the iShares Funds anticipates that it will qualify as a 'mutual fund trust' under the Tax Act at all material times."

So now you know: "ETF" doesn't mean index investing, it means exchange traded fund. "Mutual fund" does not mean active investing, it refers simply to a structure as well. Many investors are confused enough with all the terminology in this business, so let's start making a concerted effort for more precision. The necessity will become readily apparent as passively managed mutual funds explode and actively managed ETFs do the same in the coming years.

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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