ETFs versus old-fashioned tracker funds

Which of the two types of passive investing vehicle is right for you?

ETFs versus old-fashioned tracker funds Exchange Traded Funds (ETFs) and tracker funds (also known as index funds) both offer the key advantages of passive investing: namely easy access to various asset classes and instant market diversity for unbeatable cost.

Tracker funds are the older and more limited vehicle while ETFs are more innovative and flexible, and this goes to the heart of the differences between the two that you should know about.


Trade all day vs once a day

ETFs are listed on major stock exchanges (e.g. the London Stock Exchange in the UK) which means they can be traded at any time the market is open. If you want to buy an ETF at 8am and then sell again ten minutes later then you are free to do so.

Tracker funds, by contrast, only trade once a day. Times vary depending on the fund but if you put in a buy order at 8am it may not be executed until 4pm later that day. Purchase after the daily cut-off point for the fund and your order won’t go through until the next day.

The key difference here is that if you want the ability to react quickly to market events - perhaps because prices are in freefall - then ETFs are the right vehicle to choose.


Price transparency vs forward pricing

When you trade an ETF, your broker will show you the best price available at that moment. If you execute then you can expect to receive that price or very close to it under normal market conditions.

You can also instruct your broker to use limit orders that help ensure you don’t trade above or below a price you are comfortable with. Stop loss orders offer even more control, enabling you to tell your broker to sell your ETF if the price falls below a certain threshold.

Tracker funds use forward pricing which means you cannot know precisely what price you will get when you place your order. This is because a fund only calculates its price once a day at its valuation point. Whenever you trade, you will see the fund’s price at its last valuation point, but your order executes at the price determined during the next valuation point.

Prices may be similar between valuation points if the market has scarcely moved but big changes are possible during major upheavals, and you can’t use limit orders with tracker funds.


Dual pricing vs single pricing

When you come to trade an ETF you will notice that it comes with dual price tags: one to buy and one to sell. What’s more, the price you pay for an ETF will always be slightly higher than what you can sell it for.
This is known as the bid-offer spread and it’s a cost of doing business that’s collected by the middlemen who connect buyers and sellers on the stock exchange. Think of it like the small charge you pay when converting currency to go on holiday.
That cost will normally amount to pennies though on big ETFs that are heavily traded. Bid-offer spreads are more likely to be narrow on ETFs that have more assets under management (AUM) and higher daily trading volumes.
You can filter for larger ETFs by checking the Fund Size box in our ETF Screener and click through to an individual ETF’s profile to see exactly how big it is.
You can also get a feel for an ETF’s bid-offer spread by observing the sell and buy prices on its website over a couple of days. If you’re a day trader then bid-offer costs can mount up. If you trade infrequently in big, liquid ETFs then the spread will scarcely matter.
Certain tracker funds offer a single price that appears to do away with the bid-offer spread. Funds structured as Open Ended Investment Companies (OEICs) generally offer a single price while funds structured as Unit Trusts generally offer dual-pricing with a bid-offer spread.
In reality, OEICs still have to cover the cost of transactions and this is passed on to all investors through other expenses.

Trading fees vs platform fees

You will always pay a commission to your broker when trading ETFs. However, some brokers will not charge you a platform fee for holding ETFs in your account.
The reverse is true for tracker funds. You will always pay a platform fee for holding them but some brokers won’t levy trading fees.
Generally the larger your holdings, the more important it is that you avoid platform fees. While it may be more beneficial to you to avoid trading fees if you trade often and in small amounts.
A good tip is to pick a broker with a regular investment scheme that only charges £1.50 to buy. You can also purchase a single ETF at a time for your portfolio and buy quarterly or six-monthly to increase the size of your trades and thus lower the impact of trading fees.

Synthetic vs physical

All tracker funds physically hold most of the securities that make up the indices they track.
Some ETFs use a different method called synthetic replication.
This means that the ETF provider enters into an arrangement with a large financial institution (generally a global bank) that delivers the index return to the ETF while the bank receives cash and collateral in exchange.
Synthetic replication enables ETFs to track certain markets that would otherwise be inaccessible due to trading issues.
The compromise however is accepting that synthetic ETFs are exposed to the counter-party risk of a default by their financial partners. Although the risk is small you can avoid synthetic ETFs if you prefer by using the Replication Method box in our ETF Screener.
Tick the Full Replication and Sampling boxes to see physical ETFs only.

Vast choice vs limited choice

ETFs enable you to invest in a diverse and interesting range of markets from forestry to technology. You can invest purely in robotics companies, or global water or renewable energy to pick out just a few. Smart beta products are predominantly ETF based and commodities only exist in ETF or Exchange Traded Commodity (ETC) formats.
The ETF market is a fast-moving space and new ideas are continuously being tested and launched.
Tracker funds are comparatively few in number and generally restrict themselves to the biggest world and regional markets like the FTSE All-Share, S&P 500 and MSCI World.
Innovation and competition is less fierce among the major tracker fund players which means ETFs should be considered if you wish to construct as diversified a portfolio as possible.