Deciding which exchange-traded fund (ETF) to buy can be difficult when you’re presented with a handful of products tracking the same index. You might lean towards the one with the cheapest headline fee, but this won’t necessarily be the best way forward.

The impact of high charges

In many instances fees can make a big difference to performance. If you invested £1,000 into an ETF with a total expense ratio (TER) of 0.07% your money would be worth £1,618 after 10 years, assuming an annual return of 5%.

All else being equal, if you chose an ETF with a 1% TER your money would be worth £1,480 – that’s £138 less.

Because ETFs track an index you would assume an ETF with a 0.2% TER would underperform its index by 0.2% and an ETF with a 0.25% TER would underperform by 0.25%. This isn’t always the case.

‘The main factor influencing the returns of ETFs are fees, but there are other factors too which mean that an ETF charging a higher fee may produce better returns than an ETF with a lower fee,’ says Jose Garcia Zarate, associate director of passive strategies research at Morningstar.

Why tracking difference is a better measure

Although the headline fee can be a useful initial differentiator, the more important figure to look at is ‘tracking difference’. This figure shows how much less (or more) an ETF has returned relative to its index, usually over a one year period. If the FTSE 100 has grown 10% in a year and your investment returns 9.8%, your tracking difference is -0.2%.

An analysis of nine FTSE 100 ETFs by Source shows that in most cases the higher the TER the worse the tracking difference, but there are exceptions. Lyxor FTSE 100 UCITS ETF (L100) has a TER of 0.15% and a tracking difference of -0.02%. HSBC FTSE 100 UCITS ETF (HUKX) is cheaper with a TER of 0.07% but its tracking difference is -0.15%.

Causes of tracking difference

Aside from the TER, a common reason for tracking difference is the cost of buying and selling equities. This will be greater if the index rebalances frequently because the ETF will need to change its holdings accordingly. ETFs that track an index with lots of securities or which rebalance frequently due to their design will incur greater costs.

Tracking difference tends to be greater in emerging markets ETFs than in developed markets ETFs.

‘An emerging markets index is harder to replicate because the ETF is investing across a wide range of time zones with different tax and market regimes. There can also be complications around currency rates,’ says Chris Mellor, executive director at Source.

Causes of tracking difference

Total expense ratio (headline fee)

Rebalancing costs

Swap spread

Tax

Dividends

Sampling

Securities lending

Source: ETF Securities

The sampling technique

In some instances the tracking difference could be down to human error. This is particularly the case when an ETF doesn’t fully replicate the underlying index but engages in ‘sampling’. This is where the ETF buys a sample of the index’s securities because it isn’t possible nor cost-effective to buy all the securities. If an ETF uses sampling it is more likely to have a greater tracking difference because the constituents don’t exactly match the benchmark.

‘Although the management process of ETFs is highly automated, there is a human making decisions about what securities to hold in the sampling technique,’ says Garcia Zarate.

Synthetic vs physical replication

ETFs which use synthetic replication rather than physical replication show little or no tracking difference. A synthetically replicating ETF tracks an index without buying the underlying assets of the index. The ETF issuer enters into a swap agreement with a counterparty (usually an investment bank) who agrees to pay the issuer the performance of the index.

Tracking accuracy is one of the main benefits of synthetic replication, but this method exposes you to counterparty risk. There is a chance the investment bank issuing the product could go bust and fail to deliver on its obligations. It is also a more complex process to understand. As a result, some issuers only offer physically replicating ETFs.

Why some ETFs outperform

In some instances an ETF could perform better than its benchmark. This could happen where the ETF manager doesn’t have to pay as much tax as has been assumed by the index. Mellor says the S&P 500 net return index assumes the ETF will pay a 30% withholding tax on dividends. If the ETF is domiciled in Ireland the tax will be 15% because of a tax treaty between Ireland and the US.

Another reason for outperformance is dividends.

The FTSE 100 is normally quoted without dividends whereas an ETF or tracker fund always receives the dividend payments, boosting its performance.

Some ETFs engage in securities lending, the revenue of which can reduce the cost of the ETF and, in some cases, completely offset the product’s internal costs. Securities lending involves the ETF making short-term loans of the underlying stocks or bonds in the portfolio. The institution borrowing the stock must compensate the ETF and provide collateral.

Securities lending can generate extra returns for investors but it introduces more risk – the borrower could default and the collateral might not be sufficient to cover the cost of reacquiring the security.

Make sure the ETF is right for you

Fees and tracking difference aren’t the only factors to consider when choosing an investment. Adam Laird, head of ETF strategy, Northern Europe at Lyxor says you shouldn’t be tempted to buy an inappropriate investment simply because it’s cheap.

‘Think about the investments a fund holds and how the fund fits your portfolio and objectives. Make sure it’s easy to trade, to monitor and that the manager is reputable. In the end, no fee is low enough if the investment isn’t right for your circumstances,’ he adds.

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