An Investors Chronicle reader has asked about the relative merits of exchange traded funds (ETFs) versus tracker funds, and wants to know whether one is better than the other when it comes to bond exposure. The reader highlights BlackRock Index Linked Gilt Tracker (GB00B83RVT96) and iShares £ Index-Linked Gilts UCITS ETF GBP (INXG) as an example of two comparable products.
Paul Taylor, chief executive officer of independent financial adviser McCarthy Taylor, says that in some ways comparing trackers and ETFs is "like comparing cats with dogs", but cost, asset class, trading frequency and fund complexity are among the reasons why you might want to choose one over the other.
The first step when choosing any passive fund is to look at the index it tracks. If both products track the same asset class in the same way by physically holding the underlying assets, then one key differentiator might be the ongoing charge.
BlackRock Index Linked Gilt Tracker and iShares £ Index-Linked Gilts UCITS ETF track a similar basket of assets, but the ETF has a higher ongoing charge of 0.25 per cent compared with 0.16 per cent for the tracker.
There are more fundamental differences between the two, though. Securities lending is a practice whereby an ETF provider lends out the stocks it holds in return for a fee, enabling it to earn extra income. This is a common practice among providers, but introduces a small amount of extra risk and complexity, which some investors are not happy to take on.
Fund research company Morningstar says: "The ETF's ongoing charge of 0.25 per cent now looks high relative to passive funds offering this market exposure. The ETF partly offsets ongoing charges by engaging in heavy securities lending. The lending programme is well managed and controlled for counterparty risk. But we acknowledge that some investors may feel unnerved by the practice."
Another key difference is that ETFs are listed on a market, and priced and traded throughout the day, whereas unlisted open-ended investment companies (Oeics) - the typical structure of a tracker fund - are only priced once a day, offering fewer opportunities to exploit price differences. "ETFs are traded instantaneously like shares, so if you want to move in and out of markets to take advantage of ups and downs, as we did after Brexit for example, an ETF is a better option," explains Mr Taylor.
The asset class or market you want to invest in might also determine which fund type you use. Some ETFs track more niche markets than tracker funds, which tend to be broader in scope, and if you want to track a smart-beta index, which weights assets by anything other than market capitalisation, you will have to use an ETF.
"There is more variety and choice among ETFs than index trackers," says Gavin Haynes, managing director at wealth manager Whitechurch Securities. "Although both cover the major indices, such as S&P 500, FTSE 100 and many others, ETFs also offer exposure to many of the niche indices and sectors. They also offer exposure to esoteric areas such as direct commodities and leveraged strategies, but these can be highly volatile, complex vehicles, and need to be treated with caution. Index-tracking funds cover most of the major markets and regions, which is what most investors seek to hold."
For investors wanting to track a commodities index, exchange traded commodities (ETC) are the only option. This is because ETCs can track assets physically or indirectly, using derivatives such as swaps to generate their returns, and can seek to return the spot price of a commodity without physically holding it.
