ETFs Vs index funds: The ultimate battle of the trackers

ETFs and index funds help passive investors keep their investing decisions simple. Whereas complex financial products spawn amazement, desire and disappointment in roughly that order, ETFs and index funds can deliver more important things, like diversified, low-cost portfolios on limited resources.

Collectively known as index trackers, ETFs and index funds are each readymade packages of securities that deliver the return of a particular market (e.g. US equity) by tracking that market’s index.

But not all index trackers are created equal.

Despite sharing plenty of DNA, it’s worth knowing the differences between ETFs and index funds – just as you’d prepare differently for a tea party of chimpanzees versus a visit from Aunty Hilda, even though they’re 99% genetically alike.

Structure: Index fund

Most index funds are set-up as Open-Ended Investment Companies (OEICs)¹ while some are Unit Trusts. The US equivalent is the mutual fund.

OEICs and Unit Trusts are closely related. They are called ‘open-ended’ vehicles because the supply of shares in the fund is not restricted.

The fund manager can create new shares to meet demand from buyers and cancel shares to meet obligations to sellers.

Structure: ETF

The big difference between an ETF and an index fund is that ETF shares trade on the stock exchange, just like ordinary shares. In the UK, ETFs are listed on the London Stock Exchange (LSE).

Another major departure is that an ETF doesn’t necessarily hold the securities of the index it claims to track.

• Physical ETFs actually do hold the assets of their index, either replicating it in full or sampling a proportion.

• In stark contrast, a swap-based or synthetic ETF uses derivatives to track an index. The ETF hands over a basket of securities as collateral to a financial institution (such as a major investment bank) in return for a swap contract.

The ‘swap’ is a guarantee by the financial institution to pay out the return of the required index, in exchange for the performance of the collateral it’s been given.

Swaps are meant to reduce cost and tracking error. But they also expose the ETF to counterparty risk, and potential exposure to a Lehman-style collapse. If the counterparty goes bust then the ETF loses its ‘guaranteed’ return.

Some synthetic ETFs use multiple counter-parties to spread the risk. If you choose a UCITS III compliant ETF (check the ETF’s fact sheet), then the counterparty risk is limited to 10% of the ETF’s net asset value.

You can avoid counterparty risk altogether by choosing ETFs that physically replicate their index.

Pricing: Index fund

The open-ended structure of an OEIC means its price reflects the underlying value of its assets, rather than any fluctuations in supply and demand for the fund itself (unlike, say, an investment trust).

For an investor, that’s one less thing to worry about. If the fund’s assets rise in value then so does the share price of the fund. If assets fall in value, so does the fund price. Easy.

The price is calculated once a day, according to a FSA regulated formula for calculating a fund’s net asset value (NAV).

Bizarrely, you don’t normally know what price you will pay for a fund.

This blind purchase, euphemistically known as forward pricing, means you pay the price of the fund at its next valuation point (usually 12pm). So if your order is placed at 2pm, you’ll pay whatever the price is at the valuation point the next day.

It sounds wrong, it feels wrong, but there’s no getting around it. One consolation is that you’ve got about as much chance of paying a lower price as a higher one, after you’ve ordered.

Pricing: ETF

The ability to buy and sell ETFs on the stock exchange means their price is subject to change all day. They can and are traded in real-time by fast guns attempting to earn a day’s wages before breakfast, although this is a dangerous game that passive investors like me resist.

The point is ETF prices are therefore prey to the whims of the market place, so they can trade at a premium or discount to the value of their underlying assets or NAV².

Unlike investment trusts, ETF price discrepancies are nearly always very small and quickly arbitraged away by the market. Long-term investors don’t need to worry about it.

As with other shares, it’s possible to use stop, limit and open orders when buying ETFs. Limit orders are particularly useful in enabling you to set your maximum buying price and minimum selling price.

Bid/offer spread: Index fund

Unit Trusts have two prices: a buying price (bid) and a selling price (offer). This is known as the bid-offer spread.

It means you’ll pay more to buy into a fund than you will get for selling it a second later, just like when you buy foreign currency for a trip abroad. This is a cost of trading because you’re instantly down at the moment you’ve bought your units.

OEICs offer a single price, which sounds like a rare dose of normality, except the spread still exists – it’s just concealed in other charges.

Happily, the bid-offer spread isn’t just plucked out of the air by rapacious trust managers. The maximums and minimums are limited by the FSA formula mentioned above.

Naturally, a lower bid-offer spread equates to lower costs for buyers and sellers. Passive investors can rest easy though, as the cost recedes in importance over the long haul.

Bid/offer spread: ETF

The bid-offer spread of an ETF is determined by supply and demand, unlike with an index fund. The more buyers and sellers you have, the more likely the bid-offer spread will be narrow.

On a small, illiquid ETF the spread could be over 1%, which is going to hurt.

It’s a cost that needs to be taken into account when comparing ETFs, especially if your tastes run to the more exotic ends of the market.

The best way to get a tight spread (the lowest are a few hundredths of a %) is to choose large and liquid funds.

Check:

• Assets under management – a larger figure indicates a larger fund that’s likely to be more liquid.
• Daily trading volume – a high volume suggests a liquid fund with many buyers and sellers.
• Number of market makers – the higher the number the better, as they compete to drive down the bid-offer spread.

You can check the bid-offer spread and the other relevant info on the website of the ETF provider, the stock exchange, or through your broker.

Costs: Index fund

The main expense spared with index funds is broker’s commission. You don’t pay it on index funds, as they are bought directly from the fund manager rather than on the stock exchange.

This makes index funds ideally suited for small investors who want to make regular contributions.

Broker’s commission can seriously deflate returns on small investment sums, because it’s charged at a flat rate. See the section on ETF costs below for a chilling example.

Index funds generally don’t levy an initial charge, either.

The exception to the above is the Vanguard range of index funds. They’re still well worth a look though, because they could be your cheapest option if you play them right.

There is much ado online about how the total expense ratios (TERs) of ETFs are cheaper than index funds. While that’s generally true in the US, the picture is far murkier over here, and I’d dismiss that as a rule of thumb in the UK.

Costs: ETF

Broker’s commission is the big additional cost attached to ETFs that small investors need to be lively to.

You won’t pay an initial charge for an ETF, or an exit fee, the TER will be sweet, but the dealing fee you pay to buy and sell can ruin everything.

How so? Well, most good online brokers will charge around £10 per transaction.

If you want to drip-feed £50 a month into an ETF then the dealing fee just cost you 20%. Disastrous.

In fact, any dealing cost beyond 1% of your trade is excessive and I personally aim for 0.25%.

Dealing costs quickly rack up and render ETFs unsuitable for drip-feeding or frequent rebalancing, when you’re dealing in modest sums.

The way around this for small investors is to hold for the long-term and to build up large lump sums to invest. Another good tip is to use regular investment schemes that only charge £1.50 per trade.

Tax: Index fund

You pay 0.5% stamp duty to buy into a UK equity fund. The cost is usually bound up in the price you pay per share. Vanguard charges stamp duty upfront because its corporate culture errs on the side of transparency.

Tax: ETF

Stamp duty isn’t payable on ETFs.

Choice: Index fund

The world of index funds feels like a stagnant back-water next to the whirling white hot action of the ETF scene. There’s too little choice at too high a price in most market segments, while property, commodities and UK small-cap are index fund-free zones.

So you’re almost certainly going to have to buy some ETFs to build a fully diversified portfolio.

Index fund market leaders:

• Vanguard
• HSBC
• L&G

Choice: ETF

The problem with ETFs in contrast is there’s almost too much choice.

ETFs are hot, new and now. The response of the financial industry, as ever, is to pile in with a raft of innovative and exotic new products. The flip-side of innovative and exotic is risky and bewildering.

The danger is that investors are lured away from vanilla ETFs by the promise of adventure, only to come a cropper using expensive products they don’t really understand. Each to their own, but it’s worth being aware that ETFs don’t all work the same way and some track very risky markets.

Indeed, the term Exchange Traded Product (ETP) is sometimes used to encompass a family that includes:

1. Exchange Traded Commodities (ETCs) – track commodity prices.
2. Exchange Traded Notes (ETNs) – often track esoteric markets like currencies, volatility, and carbon emissions.
3. Certificates – a European version of an ETN.
4. Fundamental ETFs – track indices using fundamental measures of value (e.g. dividends, cash flow, sales, or book value) rather than weighting by market cap like conventional ETFs.

ETF market leaders:

• ishares
• HSBC
• Db x-trackers
• Lyxor
• ETF Securities

Availability: Index fund

Buy cheap index funds from an online stockbroker or fund supermarket.

Availability: ETF

You can buy ETFs cheaply from an online stockbroker.

Conclusion: Index funds win!

Whenever possible, I choose to fill my portfolio with index funds rather than ETFs. They are simpler to understand, use and manage. There are fewer complications when it comes to drip-feeding and rebalancing, and they’ve been around since 1975.

Why do I bring that up? Well, ETFs first appeared on the scene in 1993, but have really only taken off in the last five years in the UK. All things being equal, I’d rather entrust the bulk of my money to the product that’s got the longest history of avoiding financial scandal. But that’s just me and my paranoid mind.

On the subject of the mind, ETFs also bring the temptation of having a little dabble in real-time trading. (Not good!)

Still, ETFs are recommended by many of the doyens of passive investing. And I do use them myself to track parts of the market where index funds are either too expensive or simply don’t exist.

ETFs are unmatched for choice and diversity and, in the current UK market, passive investors have little option but to use both types of index tracker.

Take it steady,

The Accumulator

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1. For this reason I’ll refer to an investor’s holding in an index fund as a share (OEIC term) rather than unit (Unit Trust term) [↩]
2. NAV = (Total Value of Assets – Total Value of Liabilities) ÷ Number of Shares [↩]

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