Exchange Traded Funds (ETFs) and tracker funds are both passive investments that replicate the movement of a particular index.
They aim to deliver a return that’s in line with the performance of the tracked index, whether one of the world’s stock markets or a particular selection of shares, bonds or other assets.
In contrast, actively managed funds aim to deliver a performance that beats the fund’s stated benchmark or index, ‘actively’ buying, holding and selling stocks to try to achieve this goal.
Whichever option you choose, you have to accept that your investments can still fall in value as well as rise and you might get back less than you invest.
Learn more about active and passive funds
A common index that a tracker or ETF will follow is the FTSE 100, which includes the biggest companies listed on the London Stock Exchange. However, it’s possible to invest in other global markets, including emerging markets, as well as more esoteric assets such as timber, forestry, and global infrastructure.
The amount of money invested into ETFs in May topped $48.26 billion worldwide, marking the 40th consecutive month of net inflows.
Tracker funds meanwhile saw a net retail inflow of £933m by UK investors in April, according to latest figures from trade body, The Investment Association. Tracker funds under management stood at £150 billion as at the end of April 2017. Their overall share of industry funds under management was 13.8%, compared with 11.3% in April 2016.
Rising popularity of passive funds
Passive investments offer a low cost, diversified and simple way to invest in a range of indices, and may appeal to investors who don’t believe it’s consistently possible for a fund manager to beat the market.
Passive investments are typically cheaper than active funds, because their fees do not include paying for the skill of a fund manager to pick stocks in the hope of out-performing the market.
Investors may be charged around 0.7% of the value of their holdings per year for an actively-managed fund, in comparison to as little as 0.1% or less for some passive funds tracking the same shares. For example, one of the most popular passive funds, the iShares Core FTSE 100 ETF, charges 0.07% a year. But it’s worth bearing in mind that passive funds will always marginally under-perform their index once costs are taken into account.
It’s important to understand the fees involved in any investment, as these can have a dramatic impact on your returns over the long-term. Remember that past performance is not a guide to future performance, and all investments can go down as well as up.
Find out more about the cost of investing in funds
The difference between ETFs and trackers
Both ETFs and trackers will track a particular index, rising in value when there’s a rally, and falling during a downturn. They are also similar in that they both offer low-cost ways to access particular market indices, or the chosen underlying assets.
However, the main difference between them lies in the investment flexibility on offer. ETFs are traded on stock exchanges, meaning that prices change continually throughout the day, and they can be bought and sold like shares. Investors get a set price that should reflect the underlying index at the point that they buy or sell.
In comparison, tracker funds are structured as a unit trust or open-ended investment company (OEIC), building a portfolio reflecting a particular index, and priced once a day.
If an investor has tended to opt for open-ended funds, they may find the basic structure of a tracker fund simpler to understand than an ETF.
If you’re unsure where to invest, you may want to seek professional financial advice before investing. We don’t offer personal advice.
ETFs typically cover a wider variety of investment sectors, including clean energy and forestry, as well as the opportunity to invest in particular, smaller markets, such as Korea, or Vietnam. Bear in mind that investing in emerging markets carries greater risk than investing in developed markets, and they can be a risky and volatile asset class.
Ultimately, the choice is down to the individual investor, and will depend on your particular circumstances and investment goals.
Types of ETFs and trackers
Trackers and ETFs both buy a basket of investments in the index, but some may use more complicated investments to follow the movement of the index.
Investors can choose from ‘physical’ and ‘synthetic’ ETFs and tracker funds. A physical fund holds investments in the underlying stocks of an index, while synthetic funds rely on a counterparty, such as a bank, underwriting the risk, and paying the total return of the chosen index as cash. This means that there is the risk of the counterparty failing to meet its obligations, or being unable to pay what is due to investors.
ETFs and tracker funds may suit a wide range of investors, as part of a balanced portfolio. But before investing, ensure you understand the risks involved, particularly the counterparty risks of synthetic passive investments. Any chosen investment should suit your individual circumstances and attitude to risk, and if you’re undecided which are right for you, you should seek professional financial advice.
Many tracker funds and ETFs can be held in an Individual Savings Account (ISA), enabling investors to benefit from tax-free income and capital gains. However, remember that tax rules of ISAs can change and that the value of their favourable tax treatment depends on your individual circumstances.
Given uncertainty surrounding the impact of political and other events on markets, investors should remain focused on their long-term goals when investing in ETFs, trackers, or any other investment sector, ideally investing for at least five years.
Remember that investments can fall as well as rise, and you might get back less than you invested.
Find out more about the benefits and risks of passive investing