ETFs: stick with the cheapest options

Most exchange-traded funds (ETFs) aim to reproduce an index’s return, less fees. This is referred to as ‘passive’ investing, because trackers do relatively little buying and selling.

For a fund tracking a capitalisation-weighted index (such as the FTSE 100), trading is only necessary when stocks enter or exit the underlying index. The index itself selects companies by their market size, and buying and selling occurs when stocks cross above and below the threshold for inclusion.

In such an index fund, turnover – purchases plus sales, divided by the fund’s value – can be as low as a few per cent a year. By contrast, many active fund managers buy and sell far more frequently, sometimes pushing turnover levels to above 100%.

This incurs high costs: both explicit (such as transaction taxes and stockbrokers’ commissions) and implicit (bid-offer spreads, for example).

But the dividing line between cheap, passive ETFs and high-cost active funds is not as clear as it may seem. For a start, some indices are more active than others. As soon as you depart from the traditional method capitalisation-weighted method, you start to generate more turnover.

You’ll find a growing number of even-weighted, fundamentally weighted, low-volatility and other ‘smart beta’ ETFs on the market. Costs are typically not included in the way their returns are measured and your tracker may well underperform its index by more than the fee.

There are also some truly active ETFs that don’t follow an index at all. These funds’ holdings reflect the views of an individual fund manager.

So do active ETFs make sense? It comes down to the type of market and to costs. Bond funds have so far proved the most successful type of non-indexed ETF.

US fund manager Pimco, which operates in Europe via the Source platform, has raised several billion in assets for its active ETFs, because many investors don’t want to select bonds by index. Pimco also offered its American ETF at a fee discount to a comparable mutual fund, helping sales.

Active equity ETFs haven’t taken off to the same extent. But if you’re considering a ‘smart beta’ fund, treat it as being similar to any other actively managed fund. You can end up with the same kind of market exposure (to small caps, say, or value stocks), whichever route you take.

Just stick with the cheapest option and you shouldn’t go far wrong – but do include all costs in the comparison.

• Paul Amery, formerly a fund manager and trader, is now a freelance journalist.