I'm forever wrestling with the argument of index funds over ETFs. It's something I hear regularly from all parts of the market. We are constantly told how brilliant ETFs are - assets are booming, they're hitting record after record, the data backs it up: ETFGI reports that in Europe assets in ETF/ETPs in the year to July 2017 increased 22.2% to reach a new record of $700bn; and cash inflows enjoyed a 33
rd
consecutive month to July this year, and yet, in Europe investors are still slow to adopt them.
And it's largely to do with the ETFs' much less sexy cousin, the index tracker - the passive mutual fund; the index fund; the tracker; its various monikers. Before we split hairs, it's right to think that ETFs and index funds are both index trackers. They both try to do the same thing: passively access a broad range of assets at low cost.
But with a few fundamental differences.
To start with the first ETF was launched in the 1990s, while the first index fund was launched in the 1970s. So index funds have been around for a good while longer, meaning people are just more comfortable with them. When I speak to portfolio managers I'm told regularly they do look at ETFs, but they already use index funds for their core holdings because their investors largely take a buy and hold view and the cost is acceptable.
In other words, if it ain't broke, don't fix it - the costs are still low enough and if you're going to buy and hold then you accept there will be some dips and so, do you really need intraday trading?
Every time your ETF trades, you could be paying a fee that is on average between £7-£14 a trade. For every £100 traded that is (on average) 10%.
Of course, one of the main benefits of an ETF is its ability to trade throughout the day. Index funds are traded once a day to keep costs low.
But even here index funds have the upper hand because they tend to have better availability and visibility on platforms. Platform research house Platforum reports that adviser platforms have a higher proportion of assets in tracker funds (16.8%) over ETFs (1.3%), from its report in October 2016. This is because many platforms either don't house ETFs or the demand isn't sufficient for them to offer whole of market, and even when all ETFs are on offer, trading is sometimes aggregated to keep fees down.
Some of the ongoing fees for both index funds and ETFs are also highly competitive. The BlackRock 100 UK Equity fund costs 0.07% per annum, while the iShares FTSE 100 UCITS ETF is also 0.07%.
Your flexible friend
These are all compelling reasons in favour of the index fund. But there is still a fierce argument to be made for the ETF.
ETFs give you flexibility; while the wrapper is passive, they have the ability to sit between the passive and active sector - smart beta - injecting a bit of 'safe excitement' into the passive world. ETFs also access markets index funds just can't reach. For example, index funds don't access small cap or alternative sectors; they can even struggle with the fixed-income space.
I mentioned before that some platforms aggregate trades, which can hinder this ability to trade intraday. But only some platforms do this, others don't.
Index trackers can also charge an entry or exit fee, which is the cost of transacting the underlying securities (akin to the bid-ask spread). It means that the difference in price can be more than double if you buy and hold.
For example, the HSBC FTSE 100 UCITS ETF has a TER of 0.07%, while the HSBC FTSE 100 index fund has an OCF of 0.18%, there are also annual management charges.
The UK's RDR and now Mifid II are all about investment transparency, which you get with ETFs. This is because all ETFs have to go through the central exchange; in the UK it's the LSE, in the US NYSE Arca, and so on. This means you can see what is happening and, from January, trade reporting requirements are going to make visible the liquidity in ETF dealing.
I'm not saying ETFs are perfect. They certainly have a credible competitor in the index fund, but they go one step further with their liquidity tool. It's hard to argue against the ability to get out of a falling market quickly. The liquidity also helps price making, aids trading and accessing illiquid markets. And when you consider that ETFs cost much the same or less than index funds then this is a nice safety net. And who doesn't want a financial safety-net these days?
