What’s Cheaper: Index Funds Or ETFs?

November 15, 2012

Index funds currently offer a better deal than ETFs for most long-term savers.

 

[This article originally appeared on our sister site, IndexUniverse.eu.]


Peter Sleep, fund manager at 7IM, recently showed me a portfolio of seventeen tracker funds that his firm recommends to clients.

The 7IM balanced fund gives investors exposure to a range of equity and bond markets via trackers run by BlackRock, State Street, Royal London, HSBC and Vanguard. But only two of the seventeen trackers are ETFs—the rest are conventional index funds, offering a single daily dealing point.

Why so few ETFs? Index funds are generally cheaper than exchange-traded funds based on the same indices, says Sleep, whose balanced portfolio has a weighted average total expense ratio (TER) of a mere 0.18% a year.

Christopher Aldous, chief executive of Evercore Pan Asset, another fund manager, disagrees. In a recent video interview with the FT’s Chris Flood, Aldous says that if you compare index funds and ETFs merely on the basis of headline TERs, index funds do indeed appear a better deal.

But, Aldous adds, TERs don’t measure the frictional, transaction-based costs of investing, such as bid-offer spreads on the underlying securities, trading commissions and taxes like stamp duty. On this measure, says Aldous, index funds often produce greater tracking difference against the underlying index over time than comparable ETFs.

So who’s right?

Aldous makes an important point when highlighting that index fund investors may face costs over and above the TER. For example, a FTSE 100 index fund offered by Royal London (and held by 7IM in its balanced portfolio) charges 0.1% in annual expenses, but levies a 0.5% entry fee. This fee (often referred to as a “dilution levy”) covers the 0.5% stamp duty payable on purchases of UK-listed shares. If such a levy weren’t in place, investors entering a fund with a single dealing price would gain a small advantage over those already invested in the fund.

iShares' FTSE 100, the largest ETF based on the UK's best-known share index, is four times more expensive on an annual basis than that Royal London tracker fund, charging 0.4%. But it doesn’t levy an explicit entry fee.

Except that the iShares ETF levies an implicit one, 7IM's Sleep points out.

Most of the time the iShares FTSE 100 fund trades at a premium to its net asset value of around 0.5%, a margin that reflects the stamp duty payable on purchases of UK-listed shares to track the fund's underlying index. Other, physically replicated ETFs on the FTSE 100 from Vanguard and HSBC tend to trade at a similar premium.

(see our feature article “Tax and the FTSE” for a more detailed explanation)