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.
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
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.
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. They either replicate the index in full or sample 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. The counterparty risk should be limited to 10% of the ETF’s net asset value if you choose a UCITS compliant ETF (check the ETF’s fact sheet).
You can avoid counterparty risk altogether by choosing ETFs that physically replicate their index and that don’t partake in securities lending. Check the ETF provider’s website for its policy.
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 FCA 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.
The ability to buy and sell ETFs on the stock exchange means their price is subject to change all day – although you do at least know roughly what it is before you buy. ETFs can be 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.
Unlike investment trusts, ETF price discrepancies are generally small and quickly arbitraged away by the market. Long-term passive investors don’t need to worry because we avoid trading in illiquid instruments and at times of great market stress.
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 FCA formula mentioned above.
Naturally, a lower bid-offer spread equates to lower costs for buyers and sellers. Passive investors can rest easy though, as this cost anyway recedes in importance over the long haul, due to our lack of trading.
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%.
That 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.
- 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 information 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, if you choose a broker that doesn’t levy dealing charges on funds.
Take a look at the percentage fee brokers on our broker comparison table.
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.
If your assets amount to more than around £25,000 then you may well be better off going for a flat-fee broker and paying dealing charges. The calculation is pretty straightforward.
There is much ado online about how the Ongoing Charge Figures (OCF) 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.
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 OCF will be sweet, but the dealing charge 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 stamp duty on the underlying assets of a UK equity fund. This is a hidden cost because it’s usually bound up in the price you pay per share but it won’t be greater than 0.5%.
Leading index fund provider Vanguard charges stamp duty upfront because its corporate culture errs on the side of transparency.
The same is true of ETFs. You’ll pay the hidden costs required to purchase the underling assets of the ETF.
If you read that stamp duty isn’t payable on ETFs this is referring to the fact that you don’t pay stamp duty to acquire the actual ETF itself – unlike with investment trusts or many individual shares traded on the UK stock exchange.
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 in most market segments, and entire asset classes like commodities, value and UK small-cap are index fund-free zones.
The index fund market leaders are:
The problem with ETFs, in contrast, is there’s almost too much choice.
ETFs have caught fire in recent years and 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:
- Exchange Traded Commodities (ETCs) – track commodity prices.
- Exchange Traded Notes (ETNs) – often track esoteric markets like currencies, volatility, and carbon emissions.
- Certificates – a European version of an ETN.
- 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.
You won’t go far wrong if you stick to straightforward ETFs that track big, diverse markets like the developed world, the US, the UK, and the emerging markets.
Steer clear of products aimed at specific industries – you’re not rewarded for taking on that type of risk.
ETF market leaders:
- db X-trackers
- State Street
Availability: Index fund
Buy cheap index funds from an online broker / platform.
Same as above.
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 several 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.
Take it steady,