What’s the difference between an Exchange Traded Fund (ETF) and a tracker fund?

What you’ll learn:

• What types of investments give you exposure to indices.
• The differences between the investments.
• How to figure out which type of tracker is most suitable for you.

Let’s say you decide to add a passive fund to your portfolio. You log into your investing account, search for ‘index trackers’ and end up with a long list of potential investments.

You might be tempted to pick one based on your familiarity with a particular investment provider. But did you know that trackers come in different forms?

Trackers can either be Exchange Traded Funds (ETFs), unit trusts, or Open Ended Investment Companies (OEICs).

You need to understand the differences between these funds before you invest. Our guide can help you figure out which type of tracker is right for your portfolio.

Here’s a brief explanation of how ETFs, OEICs and unit trusts work.

What’s an Exchange Traded Fund (ETF)?

An ETF is a fund that typically tries to mirror the performance of an index such as the FTSE100 in the UK or the S&P500 in the US. An ETF trades on the stock exchange, so you can buy and sell it like shares in a company. There are two main types of ETF – physical and synthetic. A physical ETF invests directly in whatever it’s tracking. In the case of the FTSE, it invests in the companies listed on the index. A synthetic ETF uses derivatives to gain exposure to a particular market.

Find out more about ETFs and the risks when you invest

What are Open Ended Investment Companies (OEICs) and unit trusts?

OEICs and unit trusts are similar so we’ll deal with them together. They’re both open-ended funds, which means when you invest, the fund manager creates new shares in OEICs (because it’s a company) and units in unit trusts and then cancels them when you sell. The value of these shares and units directly reflects the value of the underlying investments held in the fund.

Besides tracking an index, OEICs and unit trusts can also be made up of portfolios that invest in shares, bonds, property, commodities, or a combination of different asset classes.

Find out more about OEICs and unit trusts

What makes ETFs and certain OEICs and unit trusts, passive investments?

Passive investments aim to replicate the performance of a benchmark, for example the FTSE100 in the case of an index tracker. They’re different from actively managed funds, which try to outperform a benchmark such as a market index. Actively managed funds tend to be more expensive, as they hire a team of analysts and researchers and actively trade. Passive funds, as the name suggests, don’t have the same involvement in making specific investment decisions.

Find out more about the differences between active and passive funds

What are the differences between ETFs, OEICs and unit trusts?

Now let’s look at some of the key differences between ETFs, and OEICs and unit trusts.

Transactions

Because you buy and sell an ETF on a stock exchange, you know roughly what price you’ll pay when you buy it. OEICs and unit trusts are a bit more unpredictable, as they’re subject to forward pricing. This means when you place, say, a buy order, it’s processed at the next valuation point– when the fund manager works out the price of the shares or units. Depending on market fluctuations, you could end up paying more or less than the last price available when you placed the order. It’s similar when you sell.

Costs

You’ll be charged fees by your investment service and the fund provider.

We charge a customer fee based on the value of your overall holdings, and a transaction fee every time you buy and sell an investment.

OEICs and unit trusts are categorised as funds, so you pay a 0.2% annual customer fee and a £3 online transaction fee (telephone transactions cost £25).

For an ETF, you pay a 0.1% annual customer fee and £6 online transaction fee.

These fees are charged monthly to help spread costs for investors. The table below shows the difference in costs for a £50,000 lump sum investment (for simplicity’s sake, we’re assuming no annual gains).

Please note that there’s a minimum customer fee of £4 per month.

Find out more about our fees

You also pay what’s known as an Ongoing Charge Figure (OCF) deducted from the fund by the investment provider. The OCF varies depending on the type of collective investment held and can range from below 0.2% to more than 1.5%. Passive and index products usually have the lowest fees while actively managed ones normally charge between 0.7% and 1%.

Valuation

The pricing of OEICs or unit trusts is easier to understand. Due to their open-ended structure, the price rises and falls in line with the value of the underlying investments. An ETF is subject to market forces as you buy and sell it on a stock market, so it can trade at a premium (above) or at a discount (below) to the value of its underlying investments.

Risk

Risk is unavoidable when you invest. If the value of your investment falls, you could end up getting back less than you originally put in. But there’s increased risk when you invest in an ETF – specifically a synthetic ETF. If the investment bank selling the derivative, which exposes the ETF to the underlying investment, fails to meet its obligations, you could lose money. This is known as counterparty risk.

Find out more about the risks involved

Which type of tracker fund is right for you?

You should carefully weigh up the advantages and disadvantages of the different funds before you invest in a tracker. The lower cost of an ETF may appeal, but make sure that you feel comfortable with the greater risk if you invest in a synthetic ETF. Then again, you might be willing to pay more for the greater clarity offered by OEICs and unit trusts when it comes to valuing your investments.

Whichever option you choose, your money will be at risk. The value of the underlying investments in any type of index tracker may fall and you could get back less than you invest.

Summary of differences