ETFs vs. Trust Funds: Learn the Difference

ETFs and investment trusts are each vehicles that offer investors the ability to diversify their portfolio and potentially earn a good return on their investment over time. However, these fund types have key differences to understand before choosing one over the other.  

In this article, we'll compare ETFs and investment trusts and explore the key differences between the two. 

What are ETFs? 

ETFs are investment funds that are traded on a stock exchange like individual stocks. ETFs are designed to track the performance of a particular market index, sector or asset. When an investor buys an ETF, they are buying a share in the underlying portfolio of assets, such as stocks, bonds or commodities.  

One of the benefits of investing in an ETF is that they provide easy access to a diversified basket of securities. ETFs are also typically low in cost compared to other types of investment vehicles, such as mutual funds. 

What Are Investment Trusts? 

Investment trusts are closed-ended investment funds that are listed on a stock exchange. These trusts are managed by a professional fund manager who is responsible for investing the money held in the trust. The fund manager will use this money to buy a portfolio of assets such as stocks, bonds or property. The price of the investment trust's shares is determined by the value of the assets held in the trust. 

Note that investment trusts are not the same as unit trusts. The key differences between investment trusts and other financial products like unit trusts are that they are structured as public limited companies and they issue a fixed number of shares at inception. Also, investors should keep in mind that investment trust strategies, such as borrowing, can result in even larger declines in value compared to other investment funds. 

ETFs vs. Investment Trusts: Key Differences 

One of the main differences between ETFs and investment trusts is their structure. ETFs are open-ended, meaning that the number of shares available can increase or decrease based on demand. Investment trusts, on the other hand, are closed-ended, meaning that there is a fixed number of shares available. 

Another key difference between the two is how they are traded. ETFs can be bought and sold on a stock exchange throughout the trading day, just like individual stocks. However, investment trusts are only traded once per day at the end of the trading day. 

Finally, the cost structure of ETFs and investment trusts is different. ETFs are typically lower in cost than investment trusts because they are designed to track an index and require less active management. Investment trusts, on the other hand, are actively managed and therefore may have higher fees. 

Advantages of ETFs 

ETFs offer investors many advantages, including diversification, low costs, easy trading, tax efficiency, transparency and accessibility. These benefits make ETFs an attractive investment option for experienced and novice investors alike. 

Advantages of ETFs include: 

• Diversification: ETFs offer investors the ability to diversify their portfolio across a wide range of assets, such as stocks, bonds, commodities or even alternative investments. This diversification can help reduce risk by spreading an investor’s money across a variety of investments. 
• Low costs: ETFs typically have lower expense ratios compared to actively managed mutual funds. This means more money remains invested rather than going toward fund operating costs, thereby helping to boost returns over time. 
• Easy trading: ETFs are traded on an exchange, just like stocks. This means investors can buy and sell ETFs throughout the trading day and have the flexibility to trade them in a variety of ways, including through a broker or online. 
• Tax efficiency: ETFs are structured to be tax efficient, which means they generate fewer capital gains than mutual funds. ETFs are also less likely to distribute capital gains to investors, which can help reduce the tax burden. 
• Transparency: ETFs provide transparency by publishing their holdings on a daily basis. This means investors can see exactly what the fund is holding and make decisions accordingly. 
• Accessibility: ETFs are accessible to a wide range of investors, regardless of their level of experience or the amount of capital they have to invest.  

Advantages of Investment Trusts 

Investment trusts offer a number of advantages, including diversification, ability to borrow and income potential. 

Advantages of investment trusts include: 

• Diversification: Investment trusts pool money from multiple investors and use the funds to invest in a diversified portfolio of assets, which can help to spread risk. 
• Professional management: Investment trusts are managed by investment professionals who have access to market research and analysis and can make informed investment decisions on behalf of their investors. 
• Cost effective: Investment trusts are often more cost effective than other types of investments, such as unit trusts or mutual funds, as they do not charge the same level of ongoing management fees. 
• Ability to borrow: Investment trusts have the ability to borrow money to invest in assets, which can enhance returns when investment opportunities are available. 
• Income potential: Investment trusts can retain up to 15% of their income in any given year, which means they can pay a higher level of dividends than other investment vehicles. 

Disadvantages of ETFs 

While ETFs have several advantages, there are also some potential disadvantages that investors should be aware of, including the potential for tracking error and concentration risk. 

Disadvantages of ETFs include: 

• Trading costs: ETFs can be traded on exchanges like stocks, which means investors may pay brokerage fees and other transaction costs, depending on the brokerage. These costs can eat into returns over time. 
• Tracking error: While ETFs are designed to track the performance of an underlying index, they may not always perfectly mirror the index's performance due to factors such as trading costs, cash drag and imperfect replication of the index's holdings. 
• Liquidity: While many ETFs are highly liquid and can be easily traded, some may have lower trading volumes or be illiquid, which can make it difficult to buy or sell shares at a fair price. 
• Concentration risk: Some ETFs are heavily concentrated in a single sector, asset class or geographic region, which can increase the risk of losses if that sector or region experiences a downturn. 
• Limited control over portfolio: While ETFs offer investors exposure to a diversified portfolio of assets, investors have limited control over the specific assets included in the portfolio. 
• Tax implications: ETFs can generate capital gains taxes for investors when shares are sold, which can have tax implications for investors. 

Disadvantages of Investment Trusts 

Overall, investment trusts can offer investors a range of benefits, but investors should carefully consider the potential disadvantages, such as limited gearing and limited redemption, before investing in them. 

Disadvantages of investment trusts include: 

• Trading at a discount or premium to net asset value (NAV): Investment trusts trade on stock exchanges like other securities, and their share prices can be influenced by supply and demand. This can cause the share price to trade at a discount or premium to the NAV, which can affect investor returns. 
• Gearing: Investment trusts have the ability to borrow money to invest in assets, which can amplify returns when investments perform well, but can also increase losses when investments perform poorly. 
• Limited redemption: Unlike open-ended funds, investment trusts have a fixed number of shares, which can limit the ability of investors to redeem their holdings during times of market stress. 
• Concentration risk: Some investment trusts may have a heavy concentration in a particular sector, asset class or region, which can increase the risk of losses if that sector or region experiences a downturn. 
• Limited control over portfolio: Like ETFs, investment trusts offer investors exposure to a diversified portfolio of assets, but investors have limited control over the specific assets included in the portfolio. 
• Dividend uncertainty: While investment trusts can pay higher levels of dividends than other types of investment funds, these dividends are not guaranteed and can be cut or suspended if the trust's income falls. 

Bottom Line 

ETFs and investment trusts are investment vehicles that can help investors diversify their portfolio and potentially earn a good return over time. ETFs are open-ended and often passively managed, while investment trusts are closed-ended and actively managed. The decision to invest in an ETF or investment trust will depend on an investor’s individual investment goals and risk tolerance.