Index Trackers vs Exchange-Traded Funds: Powering Passive Investment (2024)

The ‘passive’ method of investing is an increasingly popular means of gaining exposure to the stock market. It offers access to a wide variety of shares, often at a lower cost than ‘active’ investment, the other main approach.

With passive investing, the aim is to replicate, or track, the return achieved by a certain stock market index or other benchmark, using computers to maintain a stock portfolio that shadows the target index.

This might mean copying the performance of the FT-SE 100 index in London, or the S&P 500 in the US.

Retail investors – the likes of you and me – rely on two main products to invest passively: index tracker funds, often referred to as ‘index’ or ‘tracker’ funds, and exchange-traded funds (ETFs).

Active investment management involves professionals striving to outperform a particular stock index or benchmark using analysis, experience and judgment – hence the higher costs.

According to statistics providers Morningstar, there was notable momentum behind the passive investment sector during 2021.

Over the year, ‘passives’ accounted for about a fifth of the £8.5 trillion that made up the entire European investment funds market. This was an increase of 9.5% on the previous year and compared with growth of just 2.1% achieved by actively-managed investments.

The shift to passives is perhaps not surprising when you discover that only a minority of active managers are able consistently to produce a winning record over time.

According to S&P Global, over the past 15 years nearly 90% of actively managed funds have underperformed their benchmarks. Research from broker AJ Bell found only a third (34%) of actively managed shares-based funds beat their passive alternatives in 2021.

Index trackers and ETFs each provide investors with the all-important option of diversification and both are potentially low-cost ways of gaining stock market exposure.

The basic difference between ETFs and index funds is how they are traded. ETFs can be bought and sold on trading platforms through online brokers, like stocks. Index funds are bought directly from the fund manager.

What is an index tracker fund?

American stock market investment titan Warren Buffett has described index tracking funds as making “the most sense practically all of the time”.

With index trackers, the fund managers running the portfolio choose investments with the aim of copying the performance of a particular stock index, or other investing benchmark. One, say, that’s linked to bonds, property or currencies.

How do index trackers work?

Index trackers are ‘collective’ investments. This means the money comes from pooling the contributions of thousands of investors in one pot.

Most index trackers are set up as open-ended investment companies (OEICs), while others are structured as unit trusts. Both types are ‘open-ended’ investment vehicles because there’s potentially a limitless supply of shares, or units, available in each.

Some index trackers buy all the stocks in a particular index, with the holdings ‘weighted’ to reflect any variations in the various companies’ size. This is known as full replication.

Other index fund managers use ‘optimised sampling’ to create the profile of an index without necessarily buying and owning all the underlying stocks contained within it.

What is an exchange-traded fund?

ETFs differ from index trackers because they consist instead of ‘baskets’ of securities. Shares in these baskets are then available to be bought and sold on a stock exchange throughout the trading day, at the current market price.

It’s possible to order an index fund whenever you wish, but they can only be bought for the price set at the end of each trading day.

If you are investing for the long haul – a minimum of 10 years, say – a 24-hour difference between being allowed to buy an index tracker compared with an ETF is unlikely to make much of a difference to your investment performance.

But if you’re focused on intra-day trading – looking to make money from stock market moves over the course of a trading day – ETFs may suit you better.

As with other shares, it’s possible to apply ‘stop’, ‘limit’ and ‘open’ orders when buying ETFs. These are brokerage instructions that apply when certain prices are reached and are designed to head off any nasty surprises for a would-be investor.

How does an ETF work?

So-called ‘physical’ ETFs hold the assets linked with an index in question and, as with index trackers, either replicate the index in full or rely on sampling.

‘Swap-based’ or ‘synthetic ETFs’ use financial instruments known as derivatives to track an index. In this scenario, an ETF provides a basket of securities as collateral to a financial institution (such as an investment bank) in return for a ‘swap’ contract.

The ‘swap’ is a guarantee by the institution to pay out the return of the required index, in exchange for the performance of the collateral. An ETF provider’s website should tell you whether it offers physical or swap-based products.

Almost all new passive product launches are ETFs.

In 2021, the US was one of the first countries in the world to give the regulatory green light to cryptocurrency ETFs. These give investors the opportunity of gaining exposure to crypto assets without having to store the coins themselves.

However, crypto ETFs are not currently available via the London stock exchange.

How much do passives cost?

As noted, passive investments tend to be cheaper than their actively managed counterparts.

Take an index tracking fund, for example. Regardless of whether it relies on full or partial replication, the fund ought to cost less to administer overall than it would if it employed a team of active managers.

However, you’ll still need to pay an annual fee to cover an index fund’s administration costs. The average expense ratio of passively managed funds – the amount investors are charged for investing – stood at around 0.06% in 2020, according to the Investment Company Institute, the global industry organisation.

This compared with a figure of more than ten times that amount (0.71%) for actively managed US equity funds.

Applying these figures, a £10,000 investment in a passive and active fund would cost £6 and £71 respectively. In this example, additional charges – administrative, dealing, etc – may also apply depending on where a fund was bought.This might be through an investing platform or trading app or via a financial adviser. Whichever channel you choose, charges eat into your investments’ capacity to make money. So it’s essential you pick a service that’s the most cost-effective for your personal investing needs.

Should you invest in index trackers or ETFs?

Whether you decide to invest in index trackers or ETFs is probably less important than the fact that you’re choosing to invest in passives in the first place. Both offer lower fees than active investments for equal, if not superior, long-term performance coupled with plenty of portfolio diversification.

Investing in index trackers or ETFs via a stocks and shares ISA shelters any returns your investments make from three key areas of tax: income tax, dividend tax and capital gains tax.

Launched in the 1970s, index funds have the longer track record and, on balance, are probably the easier of the pair to understand.

ETFs came into being in the early 1990s. In recent years, it is these which have attracted most of the passive investment marketing hype, possibly to the point where there is now almost too much choice in this part of the passives space.

Remember that not all ETFs work in the same way and some products track eclectic and off-the-beaten track markets.

With their shares-style profile, one final point to note about ETFs is that they have the potential to encourage investors to trade more frequently, which could ultimately result in higher costs.