What’s Cheaper, Index Fund Or ETF?

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)

Of course if you’re nimble you may be able to buy into an ETF like this while its premium has temporarily disappeared, as happens from time to time, while selling the fund once it’s at a premium again. But random swings in an ETF’s price by comparison with the fund’s net asset value can just as easily work against you. See my colleague Dave Nadig’s latest article, in which Dave points out the swing from premium to discount that’s just occurred in US-listed high-yield bond ETFs.

So index fund investors may indeed face transaction-related costs via an extra entry or exit charge. But for ETF investors transaction costs in the underlying securities don’t magically disappear. They may hit you via a wide bid-offer spread on the fund, a premium (or discount) against NAV or an additional (and sometimes undisclosed) swap spread in derivatives-based funds.

Which means, ultimately, that we fall back on the TERs we started with. So I’m with Peter Sleep in the index funds versus ETFs cost debate.

If index funds score better on a TER basis than ETFs, it’s probably partly because index fund ranges aren’t marketed with the same intensity as their exchange-traded fund cousins. Someone—the ETF investor—has to bear that extra marketing cost. ETFs also offer intraday tradeability, an option that traders and some investors are willing to pay a bit more for.

But if you’re a long-term saver it’s the year-in, year-out cost that will affect you most. And on that basis ETFs have some catching up to do to match index funds’ low charges. The good news is that the recent competitive battles we’ve been reporting on, both within the ETF market and amongst index firms, are pushing fees down further. And that makes the high cost of many active funds stand out even more starkly.

  • Luke Handt

    Luke Handt is a seasoned cryptocurrency investor and advisor with over 7 years of experience in the blockchain and digital asset space. His passion for crypto began while studying computer science and economics at Stanford University in the early 2010s.

    Since 2016, Luke has been an active cryptocurrency trader, strategically investing in major coins as well as up-and-coming altcoins. He is knowledgeable about advanced crypto trading strategies, market analysis, and the nuances of blockchain protocols.

    In addition to managing his own crypto portfolio, Luke shares his expertise with others as a crypto writer and analyst for leading finance publications. He enjoys educating retail traders about digital assets and is a sought-after voice at fintech conferences worldwide.

    When he's not glued to price charts or researching promising new projects, Luke enjoys surfing, travel, and fine wine. He currently resides in Newport Beach, California where he continues to follow crypto markets closely and connect with other industry leaders.