Investing Basics: ETFs Versus Old-fashioned Tracker Funds

 

Exchange Traded Funds (ETFs) and tracker funds (also known as index funds) both offer the key advantages of passive investing – namely easy access to various asset classes and instant market diversity for unbeatable cost by Dominique Riedl

 
Tracker funds are the older and more limited vehicle while ETFs are more innovative and flexible; here are the differences you should know about.
 

Trade all day vs Once a day

 
ETFs are listed on major stock exchanges (e.g. the London Stock Exchange in the UK) and can be traded any time the market is open.

By contrast, tracker funds only trade once a day. A buy order placed at 8am may not be executed until 4pm later that day; miss the daily cut-off point for the fund and your order wll be filled the next day.

Thus, if you want to react quickly to market events – perhaps because prices are in freefall – ETFs are the right vehicle to choose.
 

Price transparency vs forward pricing

 
When you trade an ETF, your broker delivers the best price available and if you execute, you can expect to receive that price or very close to it under normal market conditions.

You may also place limit orders to help ensure you don’t trade above or below a price you are comfortable with; stop loss orders deliver even more control, instructing your broker to sell your ETF if the price falls below a certain threshold.

Tracker funds use forward pricing, so you don’t know exactly what price you will get when you place your order; a fund only calculates its price once a day at its valuation point. When you trade, you see the fund’s price at its last valuation point, but your order executes at the price determined by the next valuation point.

Prices are likely to be similar between valuation points if the market has scarcely moved, but big changes are possible during major upheavals; you can’t use limit orders with tracker funds.
 

Dual Pricing vs Single Pricing

 
An ETF comes with dual price tags: one to buy and one to sell; the price you pay for an ETF will always be slightly higher than you can sell it for.

This is the bid-offer spread – a cost of doing business, like the small currency charge you pay when going on holiday, collected by the middlemen who connect buyers and sellers on the stock exchange. The cost will only normally be pennies big ETFs that are heavily traded. Bid-offer spreads are more likely to be narrow on ETFs that have more assets under management (AUM) and higher daily trading volumes.
 

 
Get a feel for an ETF’s bid-offer spread by observing prices on its website over a couple of days. If you’re a day trader then bid-offer costs can mount up; if you trade infrequently in big, liquid ETFs then the spread will scarcely matter.

Certain tracker funds offer a single price that appears to do away with the bid-offer spread. Funds structured as Open Ended Investment Companies (OEICs) generally offer a single price while funds structured as Unit Trusts generally offer dual-pricing with a bid-offer spread.

In reality, OEICs still have to cover the cost of transactions and this is passed on to all investors through other expenses.
 

Trading fees vs Platform fees

 
You will always pay a commission to your broker when trading ETFs. However, some brokers will not charge you a platform fee for holding ETFs in your account.

The reverse is true for tracker funds. You will always pay a platform fee for holding them but some brokers won’t levy trading fees.

Generally the larger your holdings, the more important it is that you avoid platform fees. While it may be more beneficial to you to avoid trading fees if you trade often and in small amounts.

A good tip is to pick a broker with a regular investment scheme that only charges £1.50 to buy. You can also purchase a single ETF at a time for your portfolio and buy quarterly or six-monthly to increase the size of your trades and thus lower the impact of trading fees.
 

Synthetic vs Physical

 
All tracker funds physically hold most of the securities that make up the indices they track.

Some ETFs use a different method called synthetic replication.

This means that the ETF provider enters into an arrangement with a large financial institution (generally a global bank) that delivers the index return to the ETF while the bank receives cash and collateral in exchange.

Synthetic replication enables ETFs to track certain markets that would otherwise be inaccessible due to trading issues.

The compromise however is accepting that synthetic ETFs are exposed to the counter-party risk of a default by their financial partners. Although the risk is small you can avoid synthetic ETFs if you prefer by using physical replicating ETFs.
 

 

Vast Choice vs Limited Choice

 
ETFs enable you to invest in a diverse and interesting range of markets from forestry to technology. You can invest purely in robotics companies, or global water or renewable energy to pick out just a few. Smart beta products are predominantly ETF based and commodities only exist in ETF or Exchange Traded Commodity (ETC) formats.

The ETF market is a fast-moving space and new ideas are continuously being tested and launched.

Tracker funds are comparatively few in number and generally restrict themselves to the biggest world and regional markets like the FTSE All-Share, S&P 500 and MSCI World.

Innovation and competition is less fierce among the major tracker fund players which means ETFs should be considered if you wish to construct as diversified a portfolio as possible.

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