Passive investing: The choice between ETFs or index funds

Passive investing: The choice between ETFs or index funds

A combination of the Retail Distribution Review (RDR) and the financial crisis has seen the popularity of passive investing soar in recent years, as investors place increasing emphasis on cost.

For advisers and their clients, the rise of passives presents two potential opportunities: Exchange Traded Funds (ETFs) or index funds. With both sharing similarities as well as key differences, how do advisers decide which is the best route to take? 

I have already touched on the fact that cost has a big role to play in passive investing. The charges for passive funds are substantially lower than the fees for actively managed products, while the charges for ETFs also generally come in cheaper than index funds.

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Of course, no investment decision should be made on cost alone, but while an investor may be willing to pay higher charges for an actively managed fund that is performing strongly, many may find themselves less enthusiastic about doing so if the fund should suffer an extended period of losses. 

However, costs do have the potential to creep in elsewhere with ETFs through dealing charges. For consumers and advisers, ETFs have to be executed using a broker, which conventionally in retail is through a platform.

The ultimate impact of charges on an investor’s portfolio will depend on how often they choose to deal, with most retail investors opting to take more of a buy-and-hold approach over a short-term view to ETF investing. Over time, these dealing charges still have the potential to erode investment performance.

Moreover, the costs associated with trading mutual funds are almost always included as part of investment platform charges whereas ETF trades are charged separately as an additional charge, although a few platforms offer inclusive charging options that include ETFs, which means they are treated in the same way as trackers.

Perhaps the most distinctive aspect of an ETF is the ability to trade an entire market or sector as though it is one stock, allowing ETFs to be traded intraday instead of being priced just once daily like mutual funds. This aspect of ETFs is likely to be more appealing for large-scale tactical traders than retail investors, who tend to trade less frequently. However, it can still prove an important benefit, helping ensure retail investors get the best price if and when they decide it is appropriate to make a call on markets. 

An investment platform’s own dealing capabilities can be crucial here too. Most investment platforms will outsource dealing to a third party, meaning that instead of executing deals as they are placed, trading will be carried out once daily as a bulk deal, inevitably meaning the adviser loses control over timing and pricing, ultimately losing the “essence” of an ETF.

By contrast, a handful of platforms have their own in-house dealing desks that can trade directly with the market in real time which, in context, can generate price improvements equal to almost a third of the platform charge.