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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 Auntie Hilda, even though they’re 99% genetically alike.

Battle of the trackers - ETFs vs index funds

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. 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.

Pricing: ETF

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.

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 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.

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 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.

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 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 such as the Share Dealing service at Interactive Investor 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.

Tax: ETF

The same is true of ETFs. You’ll pay the hidden costs required to purchase the underlying 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:

  • Vanguard
  • BlackRock
  • Fidelity
  • HSBC
  • L&G

Choice: ETF

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:

  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.

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:

  • iShares
  • Vanguard
  • db X-trackers
  • State Street

Availability: Index fund

Buy cheap index funds from an online broker / platform.

Availability: ETF

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.

ETFs are unmatched for choice and diversity and passive investors shouldn’t worry about mixing and matching with index funds to create their ideal portfolio.

Take it steady,

The Accumulator

  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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{ 54 comments… add one }
  • 1 Dave Richardson November 16, 2010, 11:30 am

    Thanks for another very useful article. I really appreciate you ability to make financial matters comprehensible. Is there a good list UK suppliers of ETFs and/or Index funds? Or a price comparison site?

  • 2 KaKTy3 November 16, 2010, 12:14 pm

    The other negative point towards ETFs for a small investor is that by being shares they are being treated as shares by the fund supermarkets. For example, Hargreaves & Lansdown (who offer a very wide choice of UTs and OEICs) will charge the following annual fees on ETFs within their otherwise pretty good ISA product:
    • an additional annual management charge of 0.5%+VAT to a maximum of £200+VAT.

    You need to add that to TER for a like-for-like comparison.

  • 3 The Accumulator November 16, 2010, 11:23 pm

    @ Dave – Thanks, Dave. For ETFs I use this site: http://www.etfexplorer.com/uk/topics

    For index funds:
    http://www.investmentuk.org/consumer-centre/find-a-fund
    (Make sure you tick the tracker box)

    Then for belt and braces I double-check on MorningStar.

    @ KakTy3 – you can avoid that H&L fee. Try the likes of iii, x-o, TD Waterhouse (over £3600 or using their regular investment scheme).

  • 4 Gabriela November 16, 2010, 11:42 pm

    Hi Dave,

    My company is working on that and much more. If you go to the website, you can sign up for the beta.

    Gabriela

  • 5 Jenny September 9, 2012, 10:51 am

    Studying for Chartered Insurance Institutes AF4 Investment Planning exam in October and your article has been a valuable resource. Thank you.

  • 6 Trevor November 25, 2012, 8:53 pm

    I`m 21 years old with £10K to my name.
    for the past 2 weeks I`ve been trying to research ISAs, Index funds and ETFs, but the level of skewed information and conflicting fund prices out there is unbelievable.
    Idealy I`d like to invest 10 x £1000 in index funds and ETFs or on my ISA/ accumulating divideds etc for the next 10 years (until I`m old enough to figure out how to invest or what to do with the money).
    Where can I get the cheapest TERs and below 0.5% charges without having to pay silly additional charges, like non-trading penalties or paying to reinvest my dividends?
    Any good discount brokers or fund supermarkets out there?
    Trevor

  • 7 The Investor November 26, 2012, 10:33 am

    @Trevor — We can’t give personal advice, but you will find plenty of good passive investing articles on Monevator including this one on creating your own ETF portfolio and one on Vanguard’s one-stop ‘Lifestrategy‘ passive solution.

  • 8 Graham January 20, 2013, 2:44 pm

    Great website, well done!! I am a passive investing convert and in tune with your sentiments from 2010 above about mutual index funds v’s ETF’s. Are you still of the same view now 2 years on with an increasing number of ETF’s available?

  • 9 Karen February 12, 2013, 9:22 am

    TA and TI,

    In light of the fund charges being introduced by the platforms, do you think the argument has swung in favour of ETFs, or are you still of the opinion that funds ‘win’?

    I’m afraid my investing has been more catatonic than passive. Whilst on the plus side I have ridden out the downturns, unfortunately I’ve only recently woken up to how high TERs are costing me.

    I’m now looking to rearrange my ISA portfolio from the managed funds I’ve held for many years, to index trackers so I can benefit from lower costs! I was intending to go with clean funds on TD, but their announcment regarding the 0.35% charge has made me rethink that decision.

    Now undecided on whether to go with funds or ETFs, I would welcome any comment.

  • 10 The Investor February 12, 2013, 9:53 am

    @Karen — We’ll have a new article on Clean Funds in the next two hours from TA that you might find helpful. (Serendipity, rather than extremely speedy writing from the man in response to your query. 😉 ).

  • 11 The Accumulator February 15, 2013, 9:55 am

    @ Karen – it’s a closer call now but the FSA has yet to make a decision on whether platforms can no longer take commission. Some platforms – like TD – are making the move ahead of time, but some, like Cavendish Online and iWeb are sticking to the old model. We don’t know which way the FSA will go, though the decision should get made in the next 6 months.

    Let’s assume though, that explicit charges come in for all platforms. You’ll generally get charged a platform fee, no matter, what investment you hold, but some platforms, like Best Invest or Hargreaves Lansdown, don’t charge dealing fees for funds. So we end up back where we were, only at a higher price.

    I personally find there are some situations where it’s better for me to use ETFs and some where it’s better to hold funds (cost and availability of vehicle tends to vary across the asset classes), so I mix and match.

    Sorry, for the long and rambling answer, but it’s more complicated than trying to piece together a shattered vase.

  • 12 Tony August 22, 2013, 6:56 am

    Hi,

    I have been looking to get some exposure in Emerging Markets at minimum cost outside of an ISA however I am a little confused about the maths of when a fund is good or an ETF is preferred or if I am missing a factor.

    For example for a £10,000 lump sum investment:

    Vanguard FTSE Emerging Markets VFEM has an OCF of 0.45 or £45 plus trading cost with no stamp duty.

    BlackRock Emerging Markets Equity Tracker D has an OCF of 0.28% or £28 plus £50 stamp duty or £78 plus trading cost.

    So this would tell me you would be better of with the BlackRock tracker fund if you were planning on holding it (as I am) more than 2 years correct?

    Can anyone see if I am missing something else here?

    Thanks very much!

  • 13 The Accumulator August 22, 2013, 9:15 am

    Hi Tony,

    Yes, on the face of it, you’re better off with BlackRock.

    The missing elements are:

    Are there any differences in the benchmarks tracked that may make one a better bet than the other? e.g. is one more diversified than the other, does it include more mid-cap, small cap companies?

    Tracking error – most funds are prone to falling short of their benchmark. Additional costs will show up here. http://monevator.com/tracking-error-how-to-measure-it/

    Broker costs – depending on your broker you may pay no dealing cost for funds, or no platform fee for ETFs.
    http://monevator.com/compare-uk-cheapest-online-brokers/

    Neither of these options will costs you stamp duty. Stamp duty is only paid on funds dealing in UK equities.

    Hope that helps a bit!

  • 14 Tony August 28, 2013, 11:56 pm

    @ The Accumulator

    Thanks so much for the super quick reply and for clearing up the stamp duty issue! I have used the broker chart which is a huge help and I will check on the benchmark and portfolio differences.

    As you can tell I am just starting out on the road to secure a more hopeful future so I am very grateful for the guidance.

  • 15 Ross P March 7, 2014, 12:16 am

    I notice its been a while since the last comment on this article, but I’d firstly like to reiterate how useful I found it; showing that well written explinations hold their value!

    Secondly, a year on from @Karen’s comment, I was wondering if maybe the conclusion you drew it ready for another review? As you may know from my other posts, I have just opened a S&S ISA with YouInvest (AJ Bell) and as far as I can make out, they charge a 0.2% annual charge for all funds I hold, but not for ETF’s. Assuming I pick an ETF that I can invest in on a regular basis (£1.50 a go), and the TER is comparable to the equivalent Fund, then the ETF has a 0.2% bonus straight away….assuming i am investing for the long term and any bid-offer spread costs are negated!
    Have I missed something? Anyone got favourite ETFs, they’d like to recommend? The Vanguard Emerging Equities one perhaps?

  • 16 Oliver July 4, 2014, 11:45 am

    Another useful piece.
    The YouInvest ISA is appealing for this reason above, i.e. any indexes held as ETFs only hold the initial brokerage fee and the charge of the ETF. Regular investment and/or building up lump sums can help negate that.
    There are some on the internet that say that ETFs, at least physical ones, track their indexes better, and sometimes have lower fees. In the tracking error article it talks about Vanguard lending out shares etc, and as far as I know this is not the case for physical ETFs.
    It also makes pricing easier to calculate as there is no ongoing charge by the broker

  • 17 The Accumulator July 6, 2014, 7:04 pm

    Hi, I need to update the cost element of this article as recent changes now mean that most brokers will charge a platform fee for funds but no dealing fees. iWeb do not charge a platform fee but charge dealing fees.

    There are more brokers that waive their platform fee for ETFs and all will charge you dealing fees.

    Full details on how the broker’s stack up here: http://monevator.com/compare-uk-cheapest-online-brokers/

    @ Ross P – check out VRWL – Vanguard’s All World ETF – the entire global equity market in one ETF.

    @ Oliver – Stock-lending is a common practice that is product agnostic. You will find physical ETFs, active funds, investment trusts and so on can lend out stocks. It all depends on the policy of the product provider. The important thing is that they are transparent about it and share the proceeds with the investors who bear the risk.

    Generally you’d expect synthetic ETFs to track the index better than their physical counter-parts but there’s little in it. Again, much depends on the diligence of the product providers.

  • 18 Oliver July 7, 2014, 4:46 pm

    I see, thanks!

  • 19 RossP July 8, 2014, 2:34 pm

    @The Accumulator – thanks for the recommendation but I’m assuming you meant VWRL rather than VRWL?

    Having looked on the YouInvest ‘research centre’ I found two Vanguard FTSE All-World UCITS ETF’s ; one called VWRL and the other VWRD. I brought up both fact sheets and sure enough one is in pounds sterling and the other dollars – confusion solved I thought. Not so. A closer look at the USD one reports a premium of 0.02% (presumably to NAV) and a trailing return of just above the benchmark. The GBP version on the other hand reports a Discount of 41.61%(!) and a trailing return considerably below the benchmark. Surely this significant difference can’t just be down to foreign current exchange rates can it?

    Can you offer any insights?

    N.B both state a TER of 0.25% and exactly the same list of ‘Top Holdings’.

  • 20 RossP July 8, 2014, 2:49 pm

    Ah….wait, perhaps I can answer my own question. Despite the same underlying holdings, I presume these two ETFs are separately tradeable and because of their nature as ETFs as opposed to funds, the difference in premium or discount to NAV is purely down to market sentiment, meaning that people in the UK (those most likely to be buying the GBP version) currently view the worlds stock market in a much more negative light than their American counterparts.

    By this reasoning I guess I should invest asap in the GBP version as surely a 41% discount offers a cheap deal and potentially a much higher yield?

  • 21 The Accumulator July 8, 2014, 6:17 pm

    @ Ross – right, VWRL, should never trust my memory for ETF tickers.
    Where are you seeing that premium/discount information? Departures from NAV are generally arbitraged away very quickly, this piece explains: http://www.etf.com/etf-education-center/21014-what-is-the-creationredemption-mechanism.html
    Discounts on that scale are only likely to persist during a period of massive market turmoil.

  • 22 Naeclue February 3, 2015, 12:43 pm

    Good article. A few minor points.

    The FSA no longer exists, the FCA is responsible for regulation now.

    Another advantage in favour of UK domiciled UTs/OEICs for the really paranoid is that investors are protected against fraud or gross incompetence by the fund manager by an FSCS guarantee – the first £50,000 is protected for each fund provider. Not sure about Irish domiciled UTs/OEICs. With ETFs you are on your own, but I don’t think an ETF listed anywhere in the world has ever defaulted (unlike structured products).

    I would add Fidelity to your list of market leaders offering OEICs. They have recently slashed their prices as well, making them much more competitive.

  • 23 The Investor February 3, 2015, 1:13 pm

    @Naeclue — Thanks for the FSA spot! Bit silly, given we’d just updated the article, but what’s an S between faceless bureaucratic bodies. 😉 I’ve changed it in the text (indeed I am presuming the FCA retained regulation of ETFs, seeing as it remit has generally only grown wider. The Accumulator probably knows, but just wondering in light of this slip if it’s worth a double check).

    ETF domiciles/compensation is a can of worms. See this article:

    http://monevator.com/investor-compensation-scheme/

  • 24 Naeclue February 3, 2015, 1:30 pm

    A few geeky remarks about stamp duty. I hope not too OTT for an introductory article.

    On the whole investors in UTs/OEICs and ETFs can end up paying less stamp duty than people who invest directly in shares. For UTs/OEICs, the fund only has to buy new shares when cash being invested by new investors each day exceeds cash being withdrawn. If they balance, or more money is being withdrawn than invested, no shares are bought so no stamp duty paid.

    Vanguard have recently cut the charge on new investments in their UK all share tracker from 0.5% to 0.2%. The 0.5% was probably required when the fund was launched as much more money would have been invested each day than was being withdrawn. If they had not cut the charge, I suspect that they would have ended up beating the index as the extra 0.3% going into the fund was not really needed any more to offset the cost of stamp duty.

    For ETFs, stamp duty manifests itself as a premium to net asset value. UK market ETFs trade at a premium to NAV most of the time, although (for Vanguard at least) this premium averages a little under 0.5%. Provided somebody sells at the same or higher premium as purchase, they should not lose too much capital wise (there is a bid/ask spread, but that is tiny compared to stamp duty and fluctuations in NAV). But paying a premium does mean a slightly reduced dividend yield compared to that if the ETF had been bought at no discount to NAV. However, that would be the case with direct share investment as well.

    All in all I have come to the conclusion that in the UK market, UTs/OEICs should be slightly better for long term investors than ETFs with the same TER, but it is a close run thing and the decision would more more influenced by other factors such as platform charges and dealing costs, as discussed in the article.

  • 25 weenie February 3, 2015, 2:03 pm

    I’m invested in just the one ETF, the Vanguard All World High Dividend Yield (VHYL) and specifically opened an account with YouInvest as per @RossP. I too use the regular investing option so only pay £1.50 at a time.

  • 26 Gregory February 3, 2015, 5:46 pm

    @weenie – Did You know that the Vanguard FTSE All-World High Dividend Yield UCITS ETF is not a value fund? It is a blend style. See Annual report page 13. https://www.vanguard.co.uk/adviser/adv/investments/etfs/detailoverview?portId=9506&assetCode=EQUITY So The morningstar is wrong. Compare the fund charasterics. According to the morningstar the fund has 1,67 P/B but according the Vanguard factsheet the P/B is 1,9 (31/12/2014). Plus, from the launch (2010) of the FTSE All-World High Dividend Yield INDEX (not the Vanguard fund) it has underperformed the simlpe FTSE All-World INDEX. See FTSE website.

  • 27 weenie February 3, 2015, 10:40 pm

    @Gregory – hmmm…I see what you mean but I guess I could live with this for a while. It’s been invested for less than a year so I’ll just see how it goes before switching. Thanks for pointing this out for me.

  • 28 Naeclue February 3, 2015, 11:36 pm

    VHYL has lower p/e and p/b than VWRL, so the higher yielding fund is more “Value” than the normal tracker. VWRL total return for 2014 was 4.23% compared with 1.24% for VHYL. Considering annual volatility will be somewhere around 12%, the difference in performance is insignificant, but even if it was not, betting on last years winners is a really good way to lower your long term returns.

    Instead of looking at past performance, you would be better off considering charges and diversification and working out what you want to achieve with the investment. e.g. VHYL is less diversified than VWRL, but has less invested in US shares (which is probably the reason for the poorer performance last year). Is that what you want? Charges on VHYL are higher and because the yield is higher, you will pay more dividend withholding taxes and FX conversion charges on VHYL. On the other hand, VHYL has a tilt to value and has a higher dividend, which you may prefer. The value tilt might be better in the long term, but you may have to wait 20+ years to see that theory turn into reality (and it may not even then).

    Personally I would prefer not to put half of the money I allocate to equities into any one country and that would swing it to VHYL for me if that was the only equity fund I held, but I don’t think there is any clear cut reason why one ETF should be considered much better than the other. Invest in whichever suits you best, or invest 50% in each and get the average performance of the two.

  • 29 Naeclue February 3, 2015, 11:49 pm

    RossP, this sounds like poor data. Best not to rely on data from brokers or sites like Morningstar or Bloomberg. Always check the web site of the provider for reliable information before investing, in this case Vanguard. That will often mean you have to pretend you are a financial advisor or institutional investor so you can get full information on an investment.

    Unless you really want to pay the extra FX charges (or have a multi-currency broker account), always go for the ETF priced in pounds where more than one version is available.

  • 30 The Savvy Fund February 4, 2015, 12:09 am

    I would echo the point made by naeclue about compensation.

    This may be a once-in-generation event risk, but if / when it happens I would be astonished if the Irish or Luxembourg state would have the financial resources to meet claims, because the size of funds are so huge compared to the size of their economies.

    Pity there are no UK domiciled ETFs at all.

  • 31 Bob February 4, 2015, 1:39 am

    Has anyone managed to buy the GBP priced ishares physical gold ETC (SGLN) on IWEB?

    Despite showing in their Research centre only the USD version (IGLN) appears as able to purchase.

    I’ll call them tomorrow but this article seemed like too good a coincidence.

  • 32 SemiPassive February 4, 2015, 11:30 pm

    Was forced out of index funds into ETFs by the H-L charging structure changes. There are a few quirks which benefit investors who have built up a reasonable pot, especially for SIPPs as the 0.5% platform charge cap is at £200 rather than £45 for ISAs. So the goal is to build up enough to diminish the effective charge to under 0.1%.
    And the regular saver charges of £1.50 are ok if you’re bunging a few hundred quid into a single ETF or Investment Trust per month. Again, this is more likely to suit someone with an already quite diversified pot so they can progressively rebalance into one ETF/IT at a time, perhaps changing it every 6 months or yearly rather than splitting monthly investments and multiplying charges.

  • 33 NearlyThere February 7, 2015, 10:11 am

    @SemiPassive which ETFs can you drip into at HL? I thought they only did some top FTSE shares.
    I drip feed into broadly equivalent funds (for the free dealing), then swap them out into my ETFs every so often, and re-balance at that time.
    To reduce the ‘leakage’ by fees from the tax-wrapped accounts, I set up a drip feed into the fund&share account which covers the charges in ISA/SIPP, then have the charges for the tax-wrapped accounts taken from the fund&share account.

  • 34 The Accumulator February 7, 2015, 3:23 pm

    @ Naeclue – thank you for your excellent comments. Your name is misleading 😉 Fidelity now in the list.

  • 35 SemiPassive February 8, 2015, 5:54 pm

    NearlyThere, I think I’m wrong actually, having just checked under there Monthly Savings > Add Share list I can only see a few of the more well known Investment Trusts among the regular company shares, but no ETFs. Looking back I did a handful of one off ETF buys and drip feeding into City of London IT at the moment.
    Which means periodic rebalancing as you already do is the only way to top up without incurring higher transaction costs.

  • 36 PB February 18, 2015, 6:19 pm

    I’d very much like to see a pros and cons of physical ETFs vs investment trusts.

    Thanks.

  • 37 Cg August 19, 2015, 2:37 pm

    Hi, excellent article!. Just wondering if you knew what options do you have for buying passive ETFs when you are a British expat. I can’t obviously find a trading platform to buy these funds.

  • 38 The Investor August 19, 2015, 2:49 pm

    @Cg — Hi, have a look at the article below. It won’t really answer your question, but might tell you where you can do so:

    http://monevator.com/expat-investing-and-tax-us-and-uk/

  • 39 Cg August 19, 2015, 3:39 pm

    Thats v helpful. Thank you!

  • 40 Froll September 25, 2015, 3:29 pm

    Thanks for this great article 🙂

    RE pricing of ETF trackers –

    If, for whatever reason people plough into buying a global equity ETF tracker during the day, does that push its price up above what it’s really worth? i.e. above the underlying equity value of the global market at the time

    If so, this is not good, as you will ‘overpay’ for what you’re getting?

    Apologies if I’m not understanding this correctly but if it’s a tracker isn’t it supposed to ‘track’ and be representative of what it’s tracking and therefore not be swayed by people buying it up all at once for whatever reason?

    Bit confused.

    Thanks for any pointers on this 🙂

  • 41 The Accumulator September 26, 2015, 12:09 pm

    Hi Froll, arbitrage keeps ETFs honest. If the ETF’s value exceeds underlying assets then certain financial operators called authorised participants (APs) buy the underlying basket of equities in the open market and give that to the ETF provider in exchange for a new ETF share. The APs then sell that ETF share for more than they paid for the equities and they’ve got a tidy profit. They keep doing that until their constant selling of the ETF forces its price down until its back in line with underlying assets.

    It works the same in reverse if the ETF is worth less than its underlying assets. Then they buy up ETF shares and give them back to the provider in exchange for the stocks that they sell at a profit. Buying up the shares increases the price until it’s in tune with the underlying.

    This mechanism keeps values roughly where they should be and as long as you’re not buying and selling like a day trader or during peculiar market circumstances like a flash crash then you shouldn’t even notice. Try using a charting tool to chart a popular ETF against its index – you’ll notice that they track very well over reasonable lengths of time. If they don’t, they’re out of business.

  • 42 Froll September 26, 2015, 3:01 pm

    Thanks for taking the time to explain that to me, it’s very much appreciated.

    Thanks also for this informative and really helpful site, keep up the great work guys 🙂

  • 43 Slavo December 17, 2016, 4:44 pm

    This was a very useful article. I have been reading your blog for about a year now, and find your insight very helpful. On the specific topic, I’ve been looking at investing in a S&P 500 tracker of some sort, and searching for the cheapest option. I’ve looked at various index funds and ETFs, so this article helped a lot. One question I have is this:

    If ETFs have both an OCF charge AND a trading cost, why on earth would someone choose them over index funds for passive long-term investment? In this specific example, I’m looking at an iShares S&P 500 tracker ETF with 0.40% OCF + my platform’s trading fee, versus a HSBC American Index fund, with a 0.18% OCF, and a 0.10% loyalty discount from my platform, resulting in a total 0.08% OCF and zero trading cost. This is a big difference, and no matter how accurately these two track the S&P 500 index, the costs will be lower with the HSBC index fund in the long run.

    Am I missing something obvious? This looks like a no-brainer to me, but I wanted to ask if I should be looking at other things that I’m not considering.

  • 44 The Investor December 17, 2016, 4:47 pm

    This is a big difference, and no matter how accurately these two track the S&P 500 index, the costs will be lower with the HSBC index fund in the long run.

    This doesn’t answer your question (and isn’t related to those two funds you mention) but this statement isn’t quite correct, if the definition of ‘cost’ includes returns foregone. A fund with a wider tracking error over many years may well do worse than a fund with a *higher* OCF. Remember a wide tracking error may include a bunch of ‘hidden’ costs, for starters.

    Not it’s likely to be a big issue with mainstream trackers following the S&P 500 but it just jumped out at me. 🙂

    [Oops: Edited to correct my higher/lower typo! 🙂 ]

  • 45 The Investor December 17, 2016, 4:49 pm

    p.s. Thanks for the comments about the site! Hopefully my co-blogger and tracker fund maven co-blogger will come along with more thoughts for you anon, but everything is quite busy with Christmas…

  • 46 The Accumulator December 31, 2016, 8:25 pm

    Hi Slavo – sometimes ETFs are cheaper than index funds in particular categories, especially when you can buy them in blocks large enough to render the trading cost almost moot. Some platforms charge considerably more for index funds than ETFs. Sometimes you’ll find only an ETF covers the asset class you’d like to own and there is no index fund alternative. But don’t hesitate where you find a cheaper index fund.

  • 47 Haphazard February 13, 2017, 10:25 pm

    I’m about to take the plunge and buy my first ETF (Japan tracker, hedged GBP, couldn’t find an OEIC that would do this). I’ve been watching the bid/ask spread. But there’s something really basic I don’t understand. When I actually buy, the data I will have is only the latest market data. I can set a limit order to limit the maximum price I pay. But this doesn’t control the spread. When I buy OEICs, they seem to take a while to settle. So for ETFs, given that they trade all day like shares, do platforms generally execute the order much more quickly? Otherwise, what’s the point of watching the spread to decide when to buy?

  • 48 Harps March 11, 2017, 4:13 pm

    Comparing, for example a Vanguard Index fund (VDEXEIA) against its ETF equivalent (VERX), the Index fund significantly outperforms the ETF: 26.92% v 15.79% for the year up to Feb 28th. That the article above does not mention such a performance disparity clearly suggests I’m missing something…

  • 49 The Accumulator March 13, 2017, 10:06 pm

    something weird is going on there, Harps. According to Vanguard’s website, the two are clones in nigh on every respect bar returns. Same cost, same no of holdings bar 3, same top 10 holdings, same geographic and sector split. They even follow the same index, yet the index returns are reported very differently for the two funds as well. Which can’t be right. Have you emailed Vanguard about it? I’ve checked the return numbers on Morningstar and Trustnet but they don’t tally with Vanguard’s.

  • 50 Ruby August 14, 2017, 6:31 pm

    I’ve got a couple of questions (I’m new to this, so please be gentle…) :

    1. In the very helpful “Compare the UK’s cheapest online brokers” article (http://monevator.com/compare-uk-cheapest-online-brokers), below the table, there is a statement:
    “ETFs vs fund portfolios – Below around £25,000 you’re probably better off with funds.”
    I’m wondering where this assertion comes from?

    2. In the above article, I can’t really see anything relating to dividends. Generally, index funds can be bought in two flavours: “accumulation class” (dividends automatically re-invested) and “income class” (dividends paid out).
    Now as far as I know, this is not the case with ETFs – dividends are automatically paid out. (Although I think if you use Vanguard as a broker, there is an option to automatically reinvest dividends on ETFs).
    Should this difference between index funds and ETFs ever be a consideration (for someone who wants to ‘accumulate’) when trying to choose between ETFs and funds? Or is it only a consideration for those who are too lazy to reinvest their dividends every quarter?
    (I did also find this, which was useful – http://monevator.com/income-units-versus-accumulation-units-difference/)

    I hope someone (maybe even The Investor / The Accumulator) could answer the above.

    All I want to do is own the world… 😀

    … OK, I want to track the world equity markets as best as I can, and have it as a large part of my portfolio – I’m a follower of Lars Kroijer with a highish risk tolerance.

    I’m currently swaying towards Vanguard’s FTSE All-World UCITS ETF (VWRL), which seems to be a popular choice.

  • 51 The Accumulator August 18, 2017, 12:03 pm

    Hi Ruby,

    The £25K figure comes from an analysis of a fund portfolio benefitting from £0 trading fees and a low platform fee versus an ETF portfolio that pays trading fees.

    The benefits of funds reduce the less you trade, and it’s always a bespoke calculation that depends on individual circumstances. Here’s the assumptions that are used to get to the £25K rule of thumb figure for the broker table:
    “Our calculations assume one purchase per month and four sales per year, and that you take advantage of lower priced regular investment schemes when available. Portfolios consist of funds or ETFs or a 50:50 mix.”

    Some ETFs are available in accumulation flavour (also known as capitalising in ETF circles). Though it’s only a fraction in comparison to index funds. Yes, I think it should be a consideration if you’re just starting out and have a very small portfolio. Anything you can do to reduce trading charges is a good thing.

  • 52 New Investor March 1, 2018, 9:04 pm

    Hello,

    On the question of tax, I would like to refer to ivanopinion’s comment on your earlier post, which makes it seem like ETFs have a tax benefit over OEICs:

    http://monevator.com/etfs-and-the-peculiar-effects-of-withholding-tax/

    The comment is:

    “I suppose these figures all change with the introduction of the dividend tax rates for 16/17 onwards. I assume it applies to divs from US and Irish ETFs. Unless anyone knows different…

    I’ll take a stab at the new figures, but if anyone thinks I got it wrong, they are probably correct.
    1) Direct holding in US listed ETF, with form filled in to get WHT reduced to 15%:
    Assume 100 dividend. US WHT = 15
    (a) If div income is covered by personal allowance/£5k div allowance (reducing to £2k from April 2018)/ISA/SIPP, no UK tax, so total tax suffered is 15.
    (b) Basic rate taxpayer pays 7.5%, on the gross 100 div, but offset 15 WHT, so no further tax to pay. Total tax suffered is 15.
    (c) Higher rate taxpayer pays 32.5%, minus 15 credit. Total tax suffered = 32.5.

    2) Holding in UK listed, Irish domiciled ETF, which invests in US equities:
    Assume 100 dividend income earned by the ETF. US WHT = 15. ETF declares dividend of 85 to UK investor.
    (a) If div income is covered by personal allowance/£5k div allowance (reducing to £2k from April 2018)/ISA/SIPP, no UK tax, so total tax suffered is 15.
    (b) Basic rate taxpayer pays 7.5%, on the 85 div = 6.375. No WHT credit, as the ETF suffered it, not the UK investor. Total tax suffered is 21.375 (versus 15 on the US listed ETF).
    (c) Higher rate taxpayer pays 32.5% on the 85 = 27.625. Total tax suffered = 42.625 (vs 32.5 on the US listed ETF).

    So, there is still an income tax saving by buying a US listed/domiciled US index tracker ETF, rather than UK listed/Irish domiciled. Of course, the US market yields less than 2%, so the benefit is 0.2% of your investment (for a higher rate tax payer). Worth having, but is it worth the potential issues? (FX costs, US estate duty return filing, WHT form)”

    The next comment is also relevant:

    “Just for completeness, here’s my guess about the tax hit on the divs from a UK unit trust investing in US equities, under the new dividend tax rules.

    UK UT receives 100 of dividends from shares in its portfolio, but suffers 15% US WHT, so receives 85. It is taxable at 20% in UK, so UK tax on the gross income of 100 is 20, but claim tax credit for the WHT, so UT has a further 5 UK tax payable. UT has 80 income, net of tax. It then pays cash dividend of 80 to UK investor. No tax credit any more.

    Basic rate tax payer pays 7.5% on the 80, so is left with 74. Total tax cost 26 (vs 21 for UK listed foreign ETF and 15 for US listed ETF).

    40% tax payer pays 32.5% on the 80, so ends up with 54. Effective rate of tax on the underlying 100 is 46%. So, that’s 3% worse than a UK listed ETF, and 13.5% worse than a US listed ETF.

    There seems to be a definite benefit of ETFs over unit trusts/OEICs. This is because the ETF does not pay UK tax itself (assuming it is foreign domiciled).”

    It seems like, even if you avoid US-listed ETFs, a UK-listed Irish-domiciled ETF is superior to a UK-listed OEIC/UT (assuming both are investing in foreign equities) purely for tax purposes.

    Is this accurate?

    Thanks!

  • 53 John March 31, 2018, 2:27 pm

    @New Investor

    Provided the UK OEIC/unit trust invests solely into equities, then it should not pay any UK corporation tax (UK and non-UK dividends are franked, and therefore exempt from corporation tax, as are capital gains). The UK OEIC/unit trust will still be subject to US withholding taxes on US dividends received (at 15%). Therefore, there is no difference in the tax position between an Irish OEIC/ETF and a UK OEIC/unit trust – for equity funds at least.

    A UK OEIC/unit trust does have to pay UK corporation tax (at 20%) on non-dividend income received. However, they can deduct management expenses and all interest distributions to investors first. As such, there is again no difference in the tax position between an Irish OEIC/ETF and a UK OEIC/unit trust – for funds that pay interest distributions (those with more than 60% of their assets in debt instruments).

    That only really leaves a relatively small minority of funds that still have any meaningful UK corporation tax liability, because they receive a non-trivial amount of non-dividend income but are unable to declare interest distributions. It may be worth noting that multi-asset funds such the Vanguard LifeStrategy funds with 40%, 60% and 80% equity are among these (and these accounted for almost all of the UK corporation tax paid by Vanguard last financial year).

  • 54 Daffy July 1, 2018, 10:37 pm

    Harps/Accumulator – the difference in performance data between VDEXEIA and VERX is I think because the former is denominated in GBP while the latter is in EUR

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