The concepts behind exchange-traded funds (ETFs) and index-tracking funds are very similar. Both (in most cases) are created to track an index or market ‘passively’, and both are usually cheaper than traditional ‘active’ mutual funds. So why do we prefer ETFs at Nutmeg?
What are index funds?
A traditional mutual fund is actively managed – that means there is an individual fund manager or team picking individual stocks which they believe will beat a benchmark index. For example, a UK equity fund may be benchmarked against the FTSE 100 index, but the fund manager will only pick stocks within that index that she or he believes will outperform.
Unfortunately, history shows us that most active funds do not deliver in this regard. As the most recent, renowned SPIVA scorecards show, a large majority of active funds have underperformed globally on a one, three, five and 10-year basis to end of December 2021.
Passive index funds, or ‘trackers’, have been available since the 1970s, with the idea that rather than relying on stock picking skills, the fund instead buys into a pool of investments without having to buy each one individually – they ‘track’ an index. In the FTSE 100 example, the index fund is comparable to buying a small part, in the appropriate proportion, of each of the index’s 100 companies.
While the index fund is unlikely to beat the index it tracks (considering fees, it will often slightly underperform though tax efficiency or securities lending can make them outperform), it offers an easy, cost-efficient way of tracking a market. Costs are likely lower than would be feasible for an individual buying the stocks given the commissions charged for each trade and the capital required.
What are ETFs?
In relative terms, ETFs are one of the newest investment fund structures, having been developed in the 1990s. Unlike index or other mutual funds, they are always traded on a stock exchange just like equities, with their price determined through purchase and sale transactions. The first ETF listed on the London Stock Exchange, a FTSE 100 tracker from iShares, was officially launched on 28 April 2000.
Most ETFs work in a similar way to index funds in that they usually – but not always – track an index or market passively. In a relatively short time, the ETF market has grown exponentially with a huge choice of products catering for a wide array of markets and asset classes. With ETFs you can access anything from smaller companies to large blue-chip multinationals; frontier markets like Vietnam and Iceland; different sectors within an equities market, say tech or energy; even currencies.
ETFs also allow retail investors to invest in some assets that they simply wouldn’t be able to access otherwise due to accessibility or cost – such as currency hedged equities or physical gold. They have truly democratised the investment landscape, and again are easily traded at a relatively low cost to investors. They are the ideal building block for globally diversified multi-asset portfolio, such as the kind we offer at Nutmeg.
So, why do we at Nutmeg favour ETFs over traditional index funds? Here we outline the main reasons: transparency, flexibility, asset class choice, and cost.
The Benefits of ETFs over Index Funds
ETFs are transparent
It’s important at this point to note that ETFs come in two forms: synthetic and physical. Instead of holding the underlying security of the index you want to track, a synthetic ETF will instead use derivatives, arranged through a contract with a bank. Although this can be advantageous for certain exposures, these funds can be highly complex.
Instead, we prefer more straightforward physical ETFs. These hold the underlying constituents of an index and, crucially, each provider publishes a daily list of all the underlying holdings so the investor can see exactly what they are invested in. As multi-asset investors, this allows us to analyse the concentration in any one country, sector, or company, and manage risk more effectively.
It’s this level of transparency that is missing from index funds, where holdings are typically only made public with a month’s delay. Additionally, ETFs also give us transparency of cost for trading, as we’re always able to see what we’ll pay or receive before we transact.
ETFs offer flexibility
Unlike an index fund, which trades at one set price point during the day, ETFs can be traded whenever the stock exchange is open.
This provides added flexibility in portfolio management – for example, if you’re trading a fund that contains US stocks, it will likely be more efficient to do this when the US markets are open. This flexibility gives ETF investors the benefit of making timely investment decisions and placing orders in a variety of ways – just as they would with individual stocks.
ETFs offer a wider choice of assets
The ETF market is ever-expanding with over 7,000 listed globally investing across equities, bonds, and ‘alternative’ asset classes such as commodities and private equity. There remain some areas that cannot be accessed via ETFs, such as bricks and mortar physical property. This is due to issues around accessing liquidity in daily traded funds – for example, a shopping mall or office block cannot be bought and sold within one day.
Given their heritage, and that they are only priced once a day, index fund providers tend to stick to more mainstream asset classes, namely more recognised equity indices and bonds. The extraordinary development of choice being offered by ETFs has become a definite advantage.
ETFs are cost-effective
Keeping costs down is a responsibility all professional investors should take seriously, and we do this partly through using ETFs as the building blocks of Nutmeg’s diverse multi-asset portfolios. An ETF tracking a developed equity market can cost as little as 0.04%.
The total expense ratio (TER) of Nutmeg portfolios ranges from 0.11% to 0.26%. This is a measure of the cost of running the fund and the ETF provider’s fees which are charged to investors and taken from the daily value of the fund but critically also considers the fund’s performance and the costs of trading.
The next stage for ETFs
As the ETF market expands, so providers have looked for different ways of maximising the potential of the structure. In recent years, this has included the launch of factor or ‘smart beta’ ETFs, an indexing strategy which tilts towards certain performance factors that characterise an index, for ‘value’ stocks which may be considered under-priced within a market, or those which have greater ‘momentum’ in growth.
There are also ‘research-enhanced’ funds, where expert analyst teams make active security selection choices within a disciplined investment process to gain an edge on market performance. The Nutmeg Smart Alpha portfolios, powered by J.P. Morgan Asset Management, take advantage of the fractional investment expertise of one of the world’s leading investment managers.
You can read more around ETFs, why we use them, and any risks associated with the structure versus mutual funds in a dedicated section of the Nutmeg website. ETFs offer advantages that we believe are missing from other structures; they are the only funds that Nutmeg has used since we launched 10 years ago and will continue to do in building portfolios that can help our clients reach their financial goals.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.