Join our community of smart investors

Index tracker fund or ETF?

Passive funds were not created equal. We explain the key differences
November 12, 2015

Exchange-traded funds (ETFs) and index tracker funds both aim to replicate the performance of an index. But how do you choose between them?

In a new white paper focused on choosing between index tracker funds and ETFs, Vanguard, a company that offers both types of fund, says the decision comes down to four key things: investment strategy, trading flexibility, accessibility and costs.

Which is right for you will depend on the kind of investor you are, the kind of assets you want to track and the ease of access you want to have to markets.

There are many similarities between the two structures - but there are also crucial differences. An ETF is much more like a stock than a mutual fund. ETFs can be bought and sold throughout the day as they are traded on stock exchanges, meaning their price changes constantly, unlike a mutual fund which is priced only once a day.

 

When trackers are cheaper

ETFs are often hailed as the cheapest form of fund today. Many have very low ongoing charges which beat tracker funds. For example, iShares Core FTSE 100 UCITS ETF (ISF) has an ongoing charge of 0.07 per cent, lower than the cheapest tracker following the same index, the HSBC FTSE 100 Index C Acc (GB00B80QFR50), at 0.17 per cent.

But because of the constant trading and pricing of ETFs, the length of time you plan to hold a fund or ETF for and its size will have a bearing on which ends up being cheaper. A small ETF or niche ETF could have a low price tag but large trading costs - the gap between the buy and sell price - which could hurt you if you are not holding it for a long time.

According to Vanguard, the vehicle with higher transaction costs may be unfavourable for short-term trading strategies. It gives the example of deciding between an ETF with a bid-ask spread as its transaction cost and a mutual fund with no transaction costs. "Even though in this situation the ETF has an expense ratio advantage, the accumulation of transaction costs with every ETF trade may make the mutual fund the most cost-effective option," the company says.

 

Cost comparison of ETFs and trackers based on time held

Low expense ratio Higher expense ratio
Low transaction costLow ongoing charge means ETF costs lessWinner dependent on time held.
High transaction cost If ETF held for short period, mutual fund cheaper High ETF transaction costs means mutual fund likely to cost less

Source: Table adapted from Vanguard

 

Choose ETFs for smart indices and commodities

In some cases it is not possible to find the index you want to track using a passive fund. If you want exposure to indices where stocks are weighted by factors other than market capitalisation (smart beta indices) you will usually need to use an ETF.

This is the case if you wanted to track indices weighted by factors such as value or quality, where you can find a proliferation of ETFs but not mutual funds. For example, iShares, Lyxor and Deutsche Bank Asset Management all track the MSCI Europe Quality factor, but no tracker funds do. The index is a subset of MSCI Europe stocks that have been experiencing an upwards price trend and is a targeted way of playing a European index that can only be accessed via ETFs.

The same is true of other areas of ETF innovation, including indices focused on share buybacks in the US and high dividend yields in the UK. Tracker funds are available for low-volatility indexes, but if you are seeking a smart beta investment, the choice between ETF and tracker might well have been made for you.

Vanguard says: "There is a wider array of index providers and index-construction methodologies used by ETFs as opposed to mutual funds. ETFs offer exposure to a greater number of unique benchmarks, many of which are lesser known or more specialised than traditional benchmarks."

The same is true of commodities. Exchange-traded commodities (ETCs) are the only way to get direct exposure to commodity prices, rather than investing in the share prices of companies related to those commodities. Because of the difficulty of buying and storing large volumes of assets such as oil or metals, investors normally have to access them indirectly. ETCs buy commodities directly by investing in the futures market. Investing in ETCs is high-risk but it is often the only route for investors wanting direct exposure to equities.

Vanguard says: "Mutual funds generally cannot invest directly in physical commodities or commodity futures and instead must obtain this exposure through a combination of investments." Examples of ETCs include db Physical Palladium ETC (XPAL) and db WTI Crude Oil Booster ETC (XCT9).