We’re often asked why we prefer ETFs to mutual fund index trackers – or mutual funds.
The two product types look to achieve the same goal: to provide access to a broad range of assets at a very low cost. Both are considered passive investments – they set out to track or mirror a set portfolio of assets.
However, there are marked differences from a structural perspective, and the differences are more than skin deep. Here’s why we favour using ETFs in our portfolios at Nutmeg.
ETFs give us flexibility
The most obvious difference is that ETFs are exchange traded, so we can transact in the ETF throughout the day, rather than at one set point each day as in the case of a mutual fund tracker (typically around midday). This provides additional flexibility in managing portfolios.
The time you trade can affect the price you get. For example, if you are buying US shares, better pricing can typically be achieved when the US stock market is open.
ETFs give us transparency on cost
Flexibility is just one part of the equation. What we really like about ETFs is that we can understand the exact price at which we will purchase or sell the security, before the transaction takes place. This is critical to efficiently managing portfolios, and to many investors’ surprise this is not the case with tracker funds.
Because a mutual fund index tracker prices and trades once a day, you will not know the price at which you have bought or sold until after the transaction. In a mutual tracker fund, if we were to place a sell instruction at 2pm today, we would not know the price we had received for the securities until after 12 noon tomorrow (and the market might move between now and then). With an ETF, we would sell the securities immediately at 2pm. This means if the pricing is not attractive, we can choose not to go ahead at that time.
Additionally, many trackers charge what is known as a ‘dilution levy’ on entry or exit. Very simply, this is a charge that reflects the cost of transacting in the underlying securities, and protects other investors from the costs of buying or selling your securities. This is similar to the bid-ask spread seen in ETFs, except with one important difference – we have full transparency on the cost of transacting in the ETF at the time of transaction.
ETFs have a secondary market
Another aspect of ETFs that we like is the secondary market that exists for the shares of the ETF. This is an important structural difference that can save investors considerable expense.
Let’s take an example – UK equities, which are subject to stamp duty. With a mutual fund index tracker, you will need to pay this tax when you purchase the fund, and you won’t recoup this when you sell. When you buy an ETF from another investor, because you don’t interact with the underlying assets, you don’t pay stamp duty – although you do pay a premium roughly equal to stamp duty, to compensate the creator of the ETF for that cost. However, when you sell on that ETF, you will likely recoup the value of the premium from the new buyer.
The secondary market can offer investor’s savings in other assets too. In emerging markets and some bond markets, the costs of buying and selling the underlying securities can be very high. Because the ETF units already exist, it means investors are able to gain exposure to the market through the ETF, without actually having to buy and sell the underlying securities. The cost of purchasing the ETF (the bid-ask spread) in the secondary market can often be lower than purchasing all of the individual securities themselves.
ETFs offer a broader opportunity set
Finally, the range of ETFs on offer is simply much broader than that of index funds. ETFs offer access to many assets that tracker funds do not, and in many other shapes and forms. This fact provides us with more tools with which we can implement our investment ideas, and allows us a higher degree of risk control and granularity when managing portfolios.
There are currently over 1,800 ETFs listed on the London stock exchange alone, meaning price competition is high (good for all investors), and choice is wide. In many markets, there are not only competing product providers, but also different underlying index exposures from which we can choose. Mutual trackers by comparison tend to be focused only on ‘core’ equity and bond markets, and don’t provide the depth of choice that the ETF market does.
At Nutmeg, our investment approach is based on the view that asset allocation – that is, the proportion of different investment assets that make up your portfolio – is the key decision when managing your investments. ETFs give our investment team flexibility, choice, transparency and cost efficiency in managing our portfolios.
Capital at risk.