Passive investors are developing a beady eye for bargains. And exchange traded fund (ETF) providers are reacting to this by launching cheaper funds than ever before, many of which beat their open-ended tracker fund rivals soundly on costs.
However, the different features of ETFs and tracker funds mean investors will benefit differently from each fund type depending on their investment style.
Most ETFs are significantly cheaper to run than equivalent tracker funds - which means there is more potential for profit. Tim Huver, ETF product manager at Vanguard, says many ETF providers outsource accounts, administration and statement costs to intermediaries - making them able to run them on an even thinner shoestring.
Regardless of profit margins, ETFs are often the cheapest route to index tracking you can buy. But whether this will be true for your portfolio depends on your style of investing.
For many investors, the whole point of buying an ETF is that you can trade it at any point during the day. However, fund platforms have different capabilities when dealing with securities such as ETFs. Some offer no securities dealing at all (either ETFs or stocks/shares). And others have "plugged in" an external stockbroking service and provide a limited trading service so ETFs can be traded - but trading will likely be delayed.
Platform teething problems
When you decide to trade on some platforms, you have to wait for the platform to press the magic button, causing a delay between you deciding to trade and it being executed. In this space of time, the price could move significantly and defeat the cost-cutting objective of having chosen an ETF over a tracker fund.
Fund platforms are very rehearsed at providing access to mutual funds. Typically they value investments valued at the end of the day and investors will normally receive the following day's price.
Nick Blake, head of retail at Vanguard, warns: "ETFs are continually priced on the stock market. As such, even though a price is available during the day, many platforms do not have the 'real time' capability to trade ETFs."
Platforms that do have real time capability to trade ETFs include Hargeaves Lansdown, Interactive Investor, Barclays Stockbrokers and Halifax Sharedealing.
Mr Blake adds: "What is needed is for fund platforms to make ETFs as freely available as they do funds. Of course, it is only recently that some platforms have added "no load" passive funds that don't pay rebates. There is still work to do before platforms are offering their clients full access to modern indexing solutions."
So should you be buying tracker funds or ETFs if you want to trim the fat off your portfolio to cut costs? That depends on how you want to invest:
Short-term investor with regular contributions
If you spot a bull run in the market, ETFs are a good way to hop on board, cash in and get out quickly. But if you're a short-term investor and you want to drip-feed money into your ETF - because of the charges associated with buying and selling with ETFs, you might be better off with a tracker.
Short-term investor with lump sum contribution
If you find an ETF with low costs (remember to look beyond just the TER), it may well be the cheapest possible way to track the index of your choice. Before investing, check out the tracking difference (the difference between an ETF's return and that of its benchmark over a given period) and the bid offer spread (the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it), as these can affect the true cost of your investment.
Long-term investor with regular contributions
A tracker fund with a low TER will most likely be your cheapest option, because investing regularly will incur trading charges on an ETF that will eat into your returns. When searching for a cheap tracker fund, watch out for the pre-set dilution levy - a charge to offset the expenses of the fund incurred in trading in and out of the market. This isn't included in the TER and can cost up to 0.5 per cent of your investment - depending on which index you're tracking.
Long-term investor with lump sum contribution
ETFs and tracker funds are both excellent ways for you to track indices cheaply. If you're shopping for funds and price is the most important thing, compare TERs between trackers and ETFs, but be aware that ETFs, in particular, sometimes come with all sorts of associated costs outside the TER - affecting their real cost.
