How do I know which ETF to buy when lots track the same thing?
When you’re thinking of buying an exchange-traded fund (ETF), the choice can be daunting. There are typically many funds tracking the same indices, making it difficult to know how to choose between them.
It’s not as simple as just looking at the cost, although that should certainly be a key consideration. To help you with your investment journey, here’s our guide to some of the ways you can narrow down your choice.
1. HOW TO GET EVEN CHEAPER ETFS
If you search for ‘FTSE 100 ETF’, for example, on a mainstream investment platform, you’ll see offerings from the biggest providers such as Vanguard and iShares, as well as products from groups with which you may be less familiar, like Amundi and Lyxor.
If you change your search term to something like ‘UK ETF’ and look for funds that track newer indices, you could find lower-cost product options. This is because trademarks such as FTSE, S&P and MSCI push up the cost of ETFs which use them in their product names.
‘One of the biggest costs for ETFs is the indices themselves,’ said Matt Brennan, head of passive portfolios at AJ Bell. ‘It’s worth looking at ETFs that track lesser-known indices, especially for core exposure, because you end up with the same stocks and shares but you’re not paying for the trademark of FTSE or MSCI. Do you really need that trademark to pick the 100 largest companies in the UK?’
For example, Lyxor Core Morningstar UK UCITS ETF (LCUK) costs just 0.04%, almost half that of FTSE 100-tracking ETFs but offering exposure to the same companies.
There are also ETFs which track core indices from less well-known German index provider Solactive, such as L&G UK Equity UCITS ETF (LGUK).
For exposure to the companies in the S&P 500 without paying for the S&P brand name, Lyxor Core Morningstar US Equity ETF (LCUD) costs 0.04% versus 0.07% for iShares Core S&P 500 UCITS ETF (CSP1). ‘In general, differences of as little as 0.01% or 0.02% don’t sound like much but, over a 30 or 40-year investment life, one or two basis points can turn into tens of thousands of pounds when you compound the effects,’ Brennan adds. ‘It’s worth trying to make these little savings to increase your potential wealth.’
2. UNDERSTANDING ALL THE COSTS
If you’re investing in ETFs you’re probably conscious of fund charges and the impact on your returns. With ETFs, cost can affect the tracking difference, which is the degree to which the fund’s performance differs from the index whose ups and downs it is trying to mirror.
‘Ultimately, the cause of tracking difference is usually high fees so if you go for a low fee choice you’re probably doing the right thing,’ says Peter Sleep, senior investment manager at Seven Investment Management.
While it may seem an easy decision to just go for the cheapest fund that gives you exposure to the companies or assets you want, don’t forget about trading costs.
‘Costs are important but you need to move on from just that headline cost – there are also other costs involved in buying and selling ETFs,’ says Brennan.
He explains that ETFs work like shares, they have a bid price and an offer price, and the spread between these buying and selling prices can be quite different.
‘The bid/ask spread on iShares FTSE 100 ETF (ISF) is 0.04% which doesn’t sound much but that’s actually half a year’s worth of fees as the ongoing fees are about 0.07%. Some providers could have a bid/ask spread worth three or four years’ worth of fees so you could end up paying 30 basis points or 40 basis points just to get in and out of the ETF.’
ETFs trade at a small discount or premium to net asset value, in a similar way to investment trusts but on a smaller scale. They can trade on up to a 0.5% premium when people are buying FTSE 100 ETFs, for example. When people are selling they may trade at fair value (not necessarily at a discount), says Brennan, meaning you could end up with a difference in performance, so this is something worth looking at before you buy.
Say you wanted an ETF which tracks Japan’s Nikkei 225 index. Below is a comparison of the main features of a couple of those available to buy on mainstream UK fund platforms.
While there is a slight performance difference between the two products, what really jumps out from table is the difference in cost, and this will be the primary focus for most investors.
3. STRUCTURE, SIZE AND DOMICILE
Fund structure and domicile are also something to consider. If you were searching for an S&P 500 ETF, for example, you may want to avoid those that are US-domiciled. Many UK-based investment platforms won’t even let you buy US-listed ETFs.
‘People make the mistake of buying American-listed S&P 500 ETFs which is probably the worst thing you can do because there is poor tax treatment and that can be quite complicated. Between the UK and US, and Ireland and the US, there is a double tax treaty,’ says Sleep.
He adds it’s important to make sure a product is UCITS (this means it falls under a European regulatory framework called Undertakings for Collective Investment in Transferable Securities). You can usually tell if it is a UCITS product by looking at the full name of the ETF as it should be included.
‘When you’re buying a UCITS product you get the built-in investor protections of an authorised corporate director or trustees which you don’t necessarily get with a non-UCITS product.’
Sleep also suggests you might think about fund size to keep costs down. ‘If you are going to filter funds, you might want an ETF that is more than £100m in size. There are some funds that are tiny and the cost of directors, custodians and so on can weigh on performance and add to the cost,’ he explains.
‘Other than that there’s not a lot to choose between them. Cost is probably the prime cause of tracking difference over time so going for the cheapest doesn’t hurt by any means.’