But because ETFs are bought and sold through a stockbroker they will have some up-front trading costs, such as stockbroker commission, that traditional funds won’t have.
Global ETP assets have grown from $79bn at the end of 2000 to nearly $3trn at the end of 2015, with the majority of these being in equities.
In recent years, the market has also seen growth in enhanced index (also known as smart beta) products. These also track a market index, but with certain modifications in place (eg the inclusion/exclusion of some securities using a mechanical rule) in a bid to generate modest excess returns.
Flows into smart beta ETPs totalled nearly $30bn in 2015 and the amount of global ETP assets was approximately $260bn at the end of 2015.
There has been growth in open ended passive funds too. In the case of UK domiciled funds over the past 10 years, passive open ended assets under management (AUM) increased from around £23bn to just over £100bn while the passive share of total UK funds almost doubled, from 6.6 per cent to 12.4 per cent.
How do index trackers invest?
There are three main methods:
• Full replication, where each security in the fund has been bought in the same proportion as in the target index (with modification of security holdings happening only when companies periodically enter or leave this target index)
• Partial replication, where the fund manager purchases a sample of the securities in the index that they consider to be representative of and highly correlated to the performance of the index overall
• Synthetic, where derivatives or other financial instruments are used, for example, where a provider enters into a swap agreement with an investment bank under which the latter promises to deliver the performance of the underlying index in exchange for a fee
With synthetic replication, there is a risk the counterparty, the investment bank in this example, defaults and is therefore unable to deliver the agreed performance. The last few years have seen a big shift away from synthetic to full and partial replication, at least in the UK.
Rating index trackers
Defaqto splits the universe by asset class, and whether the fund is an ETF or an Oeic/unit trust, so we are comparing like with like when rating each fund. Within each of these sub-universes the funds are ranked and scored on the following:
• Ability to track; for example, how well the fund has met its objective – we use ‘r-squared’, which measures the correlation between the returns of the fund and its respective index, over both 1- and 3-year periods.