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.
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.
A vast number of both tracker funds and ETFs are available, which can help investors diversify their portfolios. Major asset classes are covered, including equities and fixed income, although the latter is less frequently available in the ETF market.
As the name entails, all tracker funds aim to track the components of a market index, but ETFs are also available for all main indices such as the S&P. More niche products also include specialist ETFs and trackers covering sectors such as technology and property.
However, despite the extensive investment opportunities this wide range of products can bring, it can also raise some issues for investors. Only a handful of platform providers offer ETFs as part of their investment universe.
Moreover, not all the investment platforms that offer ETFs have the functionality to allow these to be held within model portfolios, a particular issue for many advisers, given the growing prominence of centralised investment propositions. The availability of index funds through a platform’s model portfolios is not an issue by comparison, as trackers are treated the same as other traditional collectives.
Both ETFs and tracker funds can still experience volatility in the same way as most other investments, although the level of volatility tends to depend on the investment scope, with broad market passives typically displaying lower volatility than more sector specific products. Regional, country-specific and even international ETFs and trackers can also be easily impacted by macro events taking place in the economies where they are invested while the credit-worthiness of countries can affect volatility too.
There are also some significant differences between the taxation of ETFs and tracker funds that investors need to consider. Tracker funds are virtually always UK domiciled so are taxed in the same way as any traditional fund, which keeps things simple.
Of the ETFs available in the UK, however, most are domiciled outside the UK (Ireland is particularly popular). When they are not domiciled in the UK, they are classified as offshore funds and the tax treatment of any gains will depend on whether the ETFs have UK Reporting Fund Status. This could potentially be very expensive if not considered when making investment decisions.
Like any investment product, ETFs and trackers will not be suitable for all investors, but as the market for passive becomes more mature and sophisticated, paying close attention to some of the finer points around their execution can help ensure clients will benefit from the core strengths of each of these products while avoiding the pitfalls.
Justin Blower is head of sales of Ascentric
Key points
For advisers and their clients, the rise of passives presents two potential opportunities: ETFs or index funds.
The most distinctive aspect of an ETF is the ability to trade an entire market or sector as though it is one stock.
Both ETFs and tracker funds can experience volatility in the same way as most other investments.
