In the world of fund management, it is a debate that refuses to go away – should passive investors stick with traditional mutual fund trackers or are they better served by opting for an exchange traded fund?
On the face of it, these products are pretty similar. Both offer investors a way of tracking specific indices, which has become an increasingly popular option for those that have lost faith and money with active managers.
Dan Draper, head of ETFs at Credit Suisse, agrees trackers and ETFs have common ground.
‘The fact is, an ETF is still an index fund, just one that is listed on a stock exchange,’ he says. ‘The real difference between the two is that an ETF has a liquidity advantage because it is traded like a share.’
This is the basic crux of the argument: due to the ways in which they operate, trackers and ETFs will suit different types of passive investor.
Deciding which route is most suitable for a particular client will largely come down to that individual’s investment time horizons.
So what do these passive investors want from an index tracker?
According to Andy Gadd (pictured), head of research at Lighthouse Group, it is relatively cheap exposure to various markets and indices around the world.
‘Even the most experienced investor can benefit from having a tracker as part of their core portfolio for one simple reason: cost,’ he says.
‘Unlike active funds, you are not paying for a skilled bank of analysts – it is effectively a black box approach.’
Cost, then, is a major issue. So how do the two compare? Prices will vary between providers so it is not always straightforward to make comparisons, points out Justin Modray, founder of website Candid Money.
‘There are potential issues which advisers and clients need to be aware of,’ he says.
‘Not all ETFs are bargain basement and charges can sometimes be high for a tracker. Also, because ETF shares are traded on the stock market, investors will have to pay stockbroker dealing fees when buying and selling.’
Effectively, when you buy an ETF you have got two other charges – the bid-offer spread and a transaction cost, which is normally around £10/£12.
So if you are buying a fund you will need to consider the total expense ratio (TER) and the cost of holding it on a platform, while if you buy an ETF you will need to consider the TER and the transaction costs.
Liquidity should also be a consideration.
Manooj Mistry, head of db x-trackers for the UK at Deutsche Bank, emphasises the point that ETFs trade on stock exchanges in exactly the same way as any other listed security.
‘That means investors can get a price for an ETF and trade in and out throughout the day,’ he says.
‘This is in contrast to just getting a price at the end of the day as is common practice with mutual funds.’
The conclusion drawn will depend on the client’s objectives, points out Draper.
‘You may generally find the annual management fees of traditional index funds are a bit lower so if you are a longer term, buy and hold investor that does not need intraday liquidity, then this might be the better option, especially if the fund has a decent tracking error,’ he explains.
However, you still need to be careful to understand what is included – and perhaps more importantly what is not – in the headline fees as although some tracker funds appear to be cheaper, this may not be the case, adds Mistry.
‘Some passive mutual funds may advertise a low total expense ratio but will not mention upfront charges such as costs to access the fund or any exit fees levied,’ he says.
’Tracking difference after costs should also be factored in.’
Don’t decide on price alone
Basing your decision solely on price can also be dangerous, according to Farley Thomas, head of ETFs at HSBC Global Asset Management.
‘Some people expect ETFs to be the cheapest things in town but they should not be as the product offers features and benefits investors should value and pay for,’ he argues.
‘For many indices, there is no real other fund option than an ETF and the good news is that they remain pretty good value.’
To illustrate the point, he uses the analogy of choosing a vehicle in which to drive off-road. ‘You would buy a 4x4 that was designed for that purpose and it is the same with ETFs,’ he says.
‘They were innovated purely for this requirement and although they have since been used for other purposes, they were essentially built for tracking.’
This, he suggests, contrasts with traditional mutual funds.
‘They were designed many decades ago to provide pooled investment options to investors and typically were actively managed,’ he adds. ‘Since then index tracking has become more popular.’
Key design features highlight the differences, adds Thomas. ‘With an ETF, the inflows and outflows do not disturb the underlying portfolio, whereas in a traditional fund there is a lot of buying and selling by investors.’
‘This means the manager typically has to buy and sell securities in the underlying portfolio, which increases transaction costs and adversely affects performance.’
It is also important to remember the variety of ETFs that are available, points out Mistry.
‘This market offers far more product choice than index mutual funds,’ he says.
‘The range of underlying indices being tracked by ETFs is expanding all the time, including exposures that index mutual funds would not be able to provide.’
Of course, that is not to say ETFs are foolproof investments.
It all depends on how the fund is put together and its overall objectives, according to Dee Brown, director of the iShares wealth team.
‘There is no perfect investment and ETFs are not perfect either,’ he says.
‘In fact, a number of lessons have been learned about risk in recent years so an adviser should look at the structural risk of how a particular ETF is constructed.’
The most important question relates to whether it is physical or synthetic. ‘If the former, then an adviser needs to establish whether the manager holds all of the securities represented by an index or just a sub set of stocks that have the same characteristics,’ he adds.
‘The good news is that synthetic or swap-based ETFs are becoming increasingly transparent and that is a positive which will help the industry develop.’
This rate of development is certainly impressive.
At the end of 2010, the global ETF industry had 2,459 funds with 5,554 listings and $1,311 billion from 136 providers on 46 exchanges around the world.
This compares with 1,943 ETFs with 3,827 listings, assets of $1,036 billion from 108 providers on 41 exchanges at the end of 2009, according to the ETF Landscape Report, published by BlackRock.
Draper certainly expects the trend for passive investing to continue.
‘We have already seen it in the institutional market where investors have become much smarter about paying the right price and making a distinction between alpha and beta,’ he says.
‘They want to save the higher fees and higher risks for alpha and if they cannot find it then they will opt instead for cheap beta, which is indexing. This approach is now filtering down through private banks and to retail investors as well.’
There is certainly room for expansion, insists Brown. ‘The flexibility of ETFs gives them the opportunity to grow at a very rapid pace,’ he says.
‘You can probably count on 20% to 25% annual growth as almost every week an adviser finds a new way to employ them in a creative way within their own strategies.’