What is the best way to track an index?

Many investors' minds will immediately turn to exchange traded funds (ETFs). But there is another passive tracker fund option: unit trusts and open-ended investment companies (Oeics). These can offer the same strategies as ETFs at similar prices, but have become increasingly overlooked by the modern investor. Is there a reason why? Is one better than the other?

On the face of it – no. There should be no reason why one product should be better than the other, if an ETF and a tracker fund follow the same index at the same price. The crux of the decision for investors comes down to what they want from their funds, what they want to invest in, how big their portfolio is, and which platforms they like to use.

The key difference between an ETF and the more traditional tracker funds is that the former is listed on a public stock exchange. This means that they can be bought and sold throughout the trading day via a broker or platform. Intra-day liquidity for ETFs, as this is known, could be very important to investors.

A tracker is purchased either directly from the asset manager or via a platform, but dealing is only done once a day, so there is a time lag between your trading order and this being settled in the fund.

So why do investors choose one or the other? There are a few things to factor in.

Additional costs on top of the management fee are a good place to start. The way ETFs are structured means they very rarely attract stamp duty. However, most platforms charge a trading fee for the purchase of shares. The cost of buying a tracker fund is a lot less. In fact, some platforms do not even have trading charges for this, absorbing the minimal cost into the overall platform fee.

Should you have a sizeable portfolio, one-off transaction costs for ETFs matter less as they will not have a meaningful impact. However, those with smaller pots and those who invest regularly should think about whether an ETF or a tracker fund is the most suitable. In this case the transaction costs of purchasing an ETF might weigh down the performance of your portfolio, compared with a more cost-effective tracker fund.

However, this does not necessarily mean tracker funds are the way to go, according to Ben Seager-Scott, chief investment strategist at wealth manager Tilney.

“Functionally, there’s no real difference between a tracker fund and an ETF. It is going to come down to costs specific to platforms. Certain platforms are geared towards low costs on funds and others to ETFs and shares. There are very few costs in buying mutual funds, whereas there tends to be a flat fee for trading listed instruments,” he says.

Peter Sleep, an investment manager at wealth firm Seven Investment Management, says the biggest advantage to investors of choosing an ETF over a tracker fund is intra-day trading.

However, he adds: “I often wonder whether intra-day trading is a good thing. I do not know what I am having for my tea this evening, and I also do not know whether the markets will go up or down later today, so not sure whether I ever need to make a call that quickly.”

Easier analysis

One perception is that ETFs are easier to analyse than tracker funds, and so private investors can wade through the plethora of options with greater ease. To some extent, this is true. As an ETF is listed and follows the same market timings as an index, you can judge how well an ETF tracks its index by looking at the tracking difference.

This figure is the return of the ETF minus the return of an index over a specific period – and should be available on most ETF factsheets. It shows you how well the ETF tracks the index, net of all fees, and the closer the gap to index the better the product in terms of fees and performance. It is expected that passive funds will underperform due to the negative impact of fees on returns, but they can also outperform if they generate revenue from lending the stock the funds own to short sellers – known as securities lending.

Such a comparison is slightly more difficult when it comes to tracker funds. This is because they, and most other unit trusts and Oeics, report their net asset values (NAV) at midday, whereas indices report at the close of the market – which is 4:30pm in the UK. This means there is a discrepancy between what the fund says it has returned, and what the market has done. Any meaningful move in the market in the second half of the day could either exaggerate or flatter a fund’s fees and performance via the tracking difference.

“ETFs can be easier to analyse from a tracking difference point of view because [you get] a gauge of costs, the drag will include the ongoing charges figure (OCF) and all the trading costs,” Mr Seager-Scott says.

However, he adds: “But then you need to look at the ETF’s bid/offer spread and how they move throughout the day, so it isn’t all positive.”

This is the other side of the ETF trading throughout the day. The price of an ETF can sometimes shift to a premium or a discount to the fund’s NAV. There are mechanisms in place to limit this, and they will never trade at similar premiums or discounts to investment trusts, but this must remain a consideration, especially if trading small amounts where even a small premium will impact returns.

Are ETFs cheaper?

The passive industry is booming in Europe, with several large firms providing core products for investors. This situation has led to a price war among passive fund companies, resulting in some fees dropping as low as 0.04 per cent.

There is also a perception that this price war has been focused on ETF products rather than passive funds. One reason for this is the exponential growth in demand for ETFs over the past decade, with some funds managing over $10bn (£7.8bn)

Yet, a comparison of passive UK equity funds shows this is not the case. There are four physically replicating ETFs that track the FTSE 100 index, and six tracker funds. The cheapest product is a tracker fund, with Vanguard and Legal & General offering funds for 0.06 per cent, the former’s fund being cheaper than its equivalent ETF. The lowest ETF charge is 0.07 per cent, from HSBC and iShares.

FTSE 100 passive funds:

Source: FE Analytics as at 20.08.2018, Morningstar, *From product providers

Industry experts do not believe there will be any price advantage from either sector. “There is cost competition for both tracker funds and ETFs and I would say their fees are broadly aligned,” says Mr Sleep.

Mr Sleep designed two multi-asset portfolios, one created solely with his preferred ETFs and one with his preferred tracker funds (note, not always the cheapest), and found that overall the tracker fund portfolio was cheaper – with an overall weighted cost of 0.13 per cent compared with the 0.16 per cent for the ETF portfolio.

Peter Sleep's passive portfolios:

Source: Seven Investment Management

Mr Seager-Scott is slightly cynical about the assumption that ETFs are cheaper, more efficient products. He says most ETF providers in the UK are businesses with American parent companies, and so growth is fuelled by the fact ETFs are much more popular in the US allowing companies to transfer products and marketing budgets over to Europe.

ETFs in the US offer tax advantages that tracker funds do not, so have a significant advantage in that market.

Product choice

One advantage of Mr Seager-Scott’s observation is that there are more products on offer via the ETF market than the tracker fund market. Investors may find that the latter tends to offer only core products and main equity and bond benchmark indices, whereas ETFs provide access to significantly more options, including commodities and sub-indices such as sector-specific benchmarks and even ones that tilt towards factors such as value, growth, momentum or income.

However, Mr Sleep feels this has given ETF providers more control over performance, and the ability to use indices that best suit their needs rather than investors'.

He adds: “ETF benchmarks are often designed specifically for the ETF providers, so they are liquid and easy to track and can have dealing costs built into them. This is due to ETFs' continuous creation and redemption process, which dictates they only hold liquid securities.

“Tracker funds tend to follow the more mainstream indices and do a pretty good job given their complexity.”

Whether you use a choose tracker funds or ETFs will come down to how often you trade, which platform you use and what exactly you want to achieve with your investment. It is always worth checking what your platform charges for transactions to see whether it’s cheaper to buy a tracker fund over an ETF or vice versa.

If you have a smaller pot, are a regular saver or active trader or only want to track mainstream benchmarks, then a tracker fund may suit you better. However, should you want a broader option of products and greater flexibility on trading, then you might prefer ETFs.

For more on which ETFs investors should consider, please see our Top 50 ETFs Guide.