ETFs vs index funds and the rise of smart beta

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.

“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.

“If minimising the cost of buying and selling is important – and intra day trading is important – ETFs might be a more attractive option.”

The rise of smart beta

There is, however, another variable to throw in the mix  – and it is known as smart beta.

A smart beta ETF uses alternative index construction rules instead of the typical cap-weighted index strategy, taking into account factors such as size, value and volatility, making it also known as factor investing.

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices.

Research by Invesco's ETF arm PowerShares shows most investors are using ETFs to access smart beta (see graph below).

Global assets in smart beta equity ETFs and other exchange traded products reached a new record high at the end of November 2016 of US$497bn, according to ETFGI, the independent research and consultancy firm.

Year to date to the end of November 2016, smart beta equity ETF/ETP assets increased by 18.1 per cent.

ETFGI reports assets invested in Smart Beta equity ETFs/ETPs listed globally reached a new record high of 497 billion US dollars at the end of November 2016

Market cap/Beta vs other forms of ETFs

Factor focused smart beta strategies allow investors to tilt their portfolios towards equity factors or styles for which they believe they will be rewarded over the long term, posing competition to active managers.

“The rise of so called ‘smart beta’ strategies has shone further light on the recent poor performance of stock picking managers in some markets,” James McManus, investment manager at robo-advice firm Nutmeg, says.

“By aiming to provide investors with systematic access to equity factors, smart beta strategies take away the ‘free lunch’ for active managers, and potentially help investors expose which of those have true stock picking skill, and which have just been harvesting a risk premia or a style factor for returns.”

However some are more sceptical of the rise of smart beta.

“I'm afraid personally I feel quite negative about the whole fad, given the confusion “smart beta” ETFs have generated amongst the retail customers that “should have” embraced them,” Luis Rivera, CEO and co-founder of robo-adviser ETFmatic.

“There is a lot of evidence that smart beta ETFs have outperformed traditional ETFs. But these studies are influenced by a short time horizon or back testing given the limited data available so far, and some are biased by  chosen market sector or don't account for the additional costs.”

“The entire point of ETFs was to offer an antidote to the active fund manager trying to outperform the market without clear rules ex-ante. I’ve seen many models and black boxes that looked great in backtesting. We prefer simplicity and transparency.”

Daniel Greenhough, investment manager at St Albans-based Lumin Wealth, flagged cost as weighing on his view of smart beta ETFs.

“The ETF provider has to pay the provider of the underlying index. It’s not always clear what percentage of the ongoing fund charge on a smart beta ETF is paid to the index provider. 

“For example, the iShares MSCI USA Value ETF has a total expense ratio of 0.2 per cent whereas the standard market cap weighted iShares ETF has a TER of 0.07 per cent. It’s not made clear how the 0.13 per cent difference is split between index provider fees and trading costs.”

laura.miller@ft.com