Top ranked UK and European equity ETFs

Most rankings systems for active funds assume that the best fund is one that beats its benchmark index by the widest margin and with the most consistency. But passive funds aim to replicate the performance of an underlying benchmark so need to be judged by different criteria.

FE Trustnet's new system (available to view at: www.trustnet.com/passive-funds) awards between one and five crowns to ETFs based on their ability to track an underlying index over a three-year period. It awards funds points for low tracking difference (the annualised relative performance of a fund compared with the underlying index over three years) and low tracking error, the volatility of the difference in those returns over three years. It also awards points for liquidity, assuming funds over £100m are likely to be easier to buy and sell with smaller gaps between the buying and selling price, the phenomenon known as bid-offer spread.

FE Trustnet only looks at UK-listed passive funds with a three-year track record and funds that track indices it thinks UK investors would be most interested in. That leaves it with around 250 funds to rate across nine asset classes including UK equities, US equities and Japanese equities.

By contrast, ratings agency Morningstar uses the same quantitative metrics to compare all funds - passive and active. The company compares funds on the basis of risk and cost-adjusted performance over three-, five- and 10-year periods. It does not look at how well passive funds track indices. However, the site also compiles a large volume of qualitative data on a variety of passive funds, including ETFs.

FE TRUSTNET'S TOP-RANKED ETFS

UK equity

In the UK equity sector five-crown ETFs tracking the FTSE 100 include db x-trackers FTSE 100 UCITS ETF Inc 1D GDP (XUKX), HSBC FTSE 100 (HUKX), iShares Core FTSE 100 UCITS ETF Inc (ISF) and Lyxor UCITS ETF FTSE 100 (L100).

All score top points for achieving a low tracking difference of between 0 and 0.4 per cent, meaning results came closely in line with the FTSE 100. They all also boasted top marks for having a low tracking error, meaning they consistently tracked their underlying benchmarks, rather than returning more volatile results.

Of all FTSE 100 trackers, L100 boasts the lowest tracking difference at -0.16 per cent, meaning it overperformed the FTSE by 0.16 per cent and had a low tracking error of 0.2 per cent. The ETF with the largest difference was ISF, with 0.37 per cent.

All are low-cost options for a portfolio, with ISF's ongoing charge recently chopped to 0.07 per cent and the others costing around 0.3-0.4 per cent.

European equity

Top spots go to Amundi ETF MKSI EMU EUR (CMU), UBS MSCI EMU SF UCITS ETF (EUR) A Acc (UC30) and iShares Core Euro Stoxx 50 UCITs ETF Acc EUR (CS51).

The most popular fund in the list by assets under management was iShares EURO STOXX 50 UCITS ETF Dis Eur (CS51), at £4,946.3m. In three years the fund has returned 77.02 per cent, not reaching the 88.31 per cent high of the MSCI EMU Small Cap index but charting above the MSCI Europe ex-UK index.

Among those with the lowest tracking difference over one year was UBS MSCI EMU SF UCITs ETF (EUR) A-Acc (UC30) at -0.11 per cent.

Quantitative rankings: Can they tell you everything?

Tracking error and difference are key metrics but they are performance-related figures and may not include all the potential costs involved in holding an ETF, known as the total cost of ownership.

Adam Laird, passive investment manager at Hargreaves Lansdown, says: "We pay a lot of attention to how the fund deals with corporate actions and index rebalance points as these involve trading and therefore the fund can incur costs."

Few experts agree about which costs are included in tracking difference and error. Jose Garcia Zarate, senior analyst at Morningstar, argues that many indirect costs do appear in the tracking error and difference metrics. But he says bid-offer spread is harder to pin down. He says: "It is fairly difficult to factor all costs into a ranking assessment because they are so variable by nature and we can only work on proxies and give indications."

Liquidity is particularly tricky to include in any metric because the number changes throughout the day. But an illiquid ETF can hit your returns as it is hard to sell it for the price you paid for it. ETFs tracking more niche markets or riskier assets might be less liquid so consider this when you invest.

Shaun Port, chief investment officer at Nutmeg, says tracking difference and error are good tools to compare ETFs. However, he feels that Trustnet's rankings miss out some interesting ETFs launched in the last three years as well as some more innovative products. Trustnet does not rank smart-beta ETFs, which take a more selective approach to replicating an index, because it designates them as active products. But Mr Port argues some are well worth a look.

Meanwhile, Alan Miller, founder of SCM Private, criticises the rankings for not taking a holistic approach to investing by failing to consider the risk and performance of different indices. He says: "Using this index is the equivalent of choosing a husband or wife based on the size of their shoes."

Michael Holland, managing director at FE Trustnet, rebuts that, saying investors need to have made those decisions before consulting a ranking. "We're not trying to understand an investor's personal situation and we're not assessing risk," he says, "That's for advisers and attitude to risk questionnaires."

OTHER OPTIONS

UK equities

Hortense Bioy, director of passive fund research at Morningstar, puts forward Ossiam's FTSE 100 minimum variance UCITS ETF 1C (UKMV), which offers exposure to a lower volatility version of the FTSE 100 and, as a newly launched smart-beta product, is not included in Trustnet's ranking. The fund has an ongoing charge of 0.45 per cent and returned 5.6 per cent in 2014 against 6.3 per cent for the index.

Morningstar's other three-star product is db x-trackers FTSE 100 UCITS ETF Inc 1D GDP (XUKX), which distributes income But according to Morningstar's analysis: "The fund has a total expense ratio of 0.3 per cent, which is towards the high-end of the range for ETFs tracking the FTSE 100." The company suggests Deutsche AM's Core holding, Db X-Trackers FTSE 100 UCITS ETF (DR) 1C (XDUK), as an alternative. This accumulating fund charges a total expense ratio (TER) of 0.09 per cent. The fund has also tracked the benchmark closely, returning 26.17 per cent since launch compared with 26.6 per cent for the index.

Mr Port likes two Vanguard products not included in Trustnet's top-flight list. He says: "Vanguard FTSE 100 UCITs ETF (VUKE) has a very competitive fee (0.09 per cent) and exceptional tracking performance since inception.

"While there are alternatives products that are slightly cheaper from a fee perspective, we believe the tracking difference in VUKE is superior on a fees-adjusted basis to alternatives. Spreads are tight, and secondary market liquidity is strong."

He also likes Vanguard FTSE 250 UCITs ETF (VMID), with a low ongoing charge of 0.1 per cent. As it was launched in 2014 it does not qualify for Trustnet's list. But he says: "While spreads can be quite a bit wider than the iShares fund, it trades at a fairly consistent premium to NAV whereas other FTSE 250 funds are often quite erratic and at a discount. As such, it is better for a long-term investor. The fund has returned 9.57 per cent in the year to date compared with the FTSE 250's 9.38 per cent.

European equities

Christopher Aldous, managing director at Charles Stanley Pan Asset, likes UBS ETF MSCI EMU Value (UB17), which hones in on book value to price, 12-month forward earnings to price and dividend yield of large- and mid-cap securities across 10 developed market countries in the economic monetary union.

Mr Port says Europe is a good place to think about currency hedging, as a result of the weak euro to sterling, and recommends popular ETF UBS ETF MSCI EMU 100% hedged to GBP UCITS ETF A-dis (UC59), not included in Trustnet's list. In the year to date the hedged product has returned 16.56 per cent compared with 8.7 per cent for UB06. Mr Port says: "Launched at the end of 2013, the fund has a strong tracking performance versus its index, with a net outperformance of 0.42 per cent since launch." However, he notes: "The fund typically has a spread about 0.05 per cent wider than the iShares unhedged fund."

Mr Aldous also likes a smart-beta ETF, the WisdomTree Europe Small Cap Dividend (DFE). WisdomTree products are weighted by annual cash dividends paid, meaning there is more chance of tracking larger, more sustainable businesses rather than smaller ones offering high yields. The fund selects the companies comprising the bottom 25 per cent of the WisdomTree Europe Dividend Index based on market capitalisation after taking out the largest 300 companies. It is not the cheapest option, with an expense ratio of 0.58 per cent but in the last quarter of 2014 offered a strong dividend yield of 3.88 per cent.

Morningstar and Trustnet top-rated

When Morningstar's return-focused ratings are included, the top-rated ETFs across the European and UK equity income sector are Amundi ETF MSCI EMU EUR (CMU), UBS ETF MSCI EMU UCITS ETF (EUR) A dis (GBP) (UB06) and UBS MSCI EMU SF UCITS ETF (Eur) A Acc (GBP) (UC30).

Each scored four stars on Morningstar's rating system and received five crowns according to Trustnet's own data. They are not the cheapest funds, with iShares' products beating them all on ongoing charge. The rankings could demonstrate the high returns of the MSCI EMU, which all of the funds track. It has beaten both the Euro Stoxx 50 and MSCI Europe in the year to date, returning 11.41 per cent. However, over the long term both indices have beaten the MSCI EMU.

The all-round winner

iShares Core FTSE 100 UCITs ETF (ISF) is the top fund of the entire list, ranked highest by Trustnet and recommended by Mr Port, Morningstar and also Mr Laird. It is the clear winner in Trustnet's UK equity ETF list when trading costs are taken into account. Despite having a higher tracking difference than other five-crown FTSE 100 funds, ISF has the lowest five-day average bid-offer spread and is the cheapest to hold when all costs are considered. ISF boasts both the lowest ongoing charge of all FTSE 100 products as well as tightest five-day average bid-offer spread.

Trustnet's top FTSE 100 ETFs with tracking metrics and bid-ask spreads

*As at 22 April 2015, Hargreaves Landown

Source: FE Trustnet

What criteria do the experts use?

No rating system can do all the work for you and tracking difference and error are backwards looking metrics and may not tell you about future performance.

Before you turn to rankings you need to have done some key due diligence to work out the complexity of your product, the index you want to track and the likelihood of being able to sell it on for the same price you bought it further down the line.

Adam Laird, passive investment manager at Hargreaves Lansdown. says:

"Broadly, I look at five categories: Index tracked, initial cost, annual cost, replication and stock lending."

Alan Miller, founder of SCM Private, says:

Firstly, you need to look at anything in investment, whether passive or active, based on the balance between risk, return and cost rather than one of these alone. Secondly, you need to look at the actual area in which the ETF invests and how the ETF invests. Thirdly, have a robust ETF filter process once you have selected which particular market you want to invest. You choose the market first, then the best ETF for that particular market not the other way round.

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Trustnet's five-crown UK equity ETFs

Source: Trustnet

Alternative UK equity ETF recommendations

Performance of alternative UK ETFs (% total return) compared with underlying index

Performance: FE Trustnet, as at 1 May 2015

Trustnet's five-crown European equity ETFs

Alternative European ETF recommendations

Source: FE Trustnet