ETFs - Spring 2017  

ETFs vs index funds and the rise of smart beta

This article is part of
Guide to exchange-traded funds

ETFs vs index funds and the rise of smart beta

As both allow investors to replicate a benchmark index, it is worth comparing ETFs to index funds.

At their heart, ETFs are simply index funds that are traded like a share on a regulated exchange. 

“In terms of similarities, ETFs and index funds both deliver to investors the benefit of diversification,” Pollyanna Mills, head of UK intermediary sales at ETF provider iShares, points out.

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“By purchasing one [index] unit or one [ETF] share, investors automatically gain exposure to a large number of securities – thus reducing their portfolio risk.”

Compared to active management, both are also low cost, with fees usually of a few basis points for mainstream share markets, and a few tens of basis points for more complex exposures such as emerging markets.

Both are also useful portfolio “building blocks” for asset allocation.

So how do ETFs and index funds differ? Mainly in how the products can be purchased or sold.

ETFs can be purchased like a common share on a stock exchange via a broker or a trading platform. 

“Investors can enter or exit their position at any given point in time,” Ms Mills points out.

Index funds can be bought or sold via fund platforms too – but are not traded on exchange, meaning investors can enter or exit the position once a day, at the net asset value of the fund, plus or minus a fee.

Cost is important comparison between ETFs and index funds. 

ETFs avoid the rebalancing costs that occur with index funds and their daily net redemptions, because shares of ETFs can be created and redeemed with a like basket of securities (creation/redemption in-kind), which avoids these transaction costs.

Cash drag – the cost of holding cash to deal with potential daily net redemptions - is another factor that affects index funds and not ETFs.

However on dividends, while index funds will invest their dividends immediately, ETFs are required to gather this cash during the quarter for distribution to shareholders at the end of that time.

On other costs, management fees are generally lower for ETFs than index funds. Annual fees are around 0.1 per cent to 0.5 per cent, according to DIY portfolio service Just ETF. For index funds it is around 0.25 per cent to 1 per cent. 

The cost of buying an ETF varies, but will usually be the standard trading fee for shares. Just ETF puts typical dealing fees for ETFs at £6-£12 per trade. 

There is also a bid/offer spread with ETFs – meaning they cost slightly more to buy than you get when you sell. Just ETF puts this difference at around 0.2 per cent to 0.5 per cent.

To sum up, whether to choose an ETF or an index fund depends on the situation, as Ms Mills points out: “If the aim of the investment is to build a buy and hold long term investment, the ability to trade throughout the day is not needed and having only one price per day makes it easier for the investor, and therefore index funds might be attractive.