Like other ETFs, an index ETF is essentially a passive mutual fund -- similar to traditional index funds -- that allows investors to purchase a basket of securities in a single transaction. An index ETF mimics part or all of an external index.
How it works/Example:
For example, the iShares Dow Jones Select Dividend Index Fund is an ETF that invests in the 100 stocks contained in the Dow Jones U.S. Select Dividend Index.
ETF shares are essentially legal claims to underlying shares held in a trust by the fund's creator or authorized participant, which is usually a market maker, specialist or institutional investor. These underlying shares are grouped into creation units, and the ETF shares are fractions of these creation units.
Unlike traditional mutual and index funds, ETFs have no front- or back-end loads. In addition, because they are not actively managed, most ETFs have minimal expense ratios, making them much more affordable than most other diversified investment vehicles. Most mutual funds also have minimum investment requirements, making them impractical for some investors.
Why it Matters:
Although ETFs hold the same stocks as their underlying indexes, the selection of the index on which to base and benchmark the fund is important because there are a variety of indexes. The Dow Jones U.S. Select Dividend Index, for example, selects 100 stocks based on whether and how much the each company has increased its dividends, each stock's trading volume over time and a variety of other factors. Some indexes include smaller companies, and some stick with larger companies; some stocks also appear in more than one dividend-stock index. Additionally, many dividend-stock indexes have assets in the same industries because some industries (utilities and financial services, for example) commonly pay dividends.http://www.investinganswers.com/financial-dictionary/mutual-funds-etfs/index-etf-5524