Two exchange traded funds that track the same market index will generate identical performance, so should you simply choose the cheapest?
‘Yes’ may seem like the obvious answer, but in reality the matter is more nuanced.
ETFs seldom replicate the performance of a given index to a tee because of something called tracking error, so it is important to look under the bonnet of each prospective investment to avoid an unwelcome surprise.
To help you on your way, we’ve taken a close look at the best performing FTSE 100 ETFs to see how they compare and how to pick between them.
Like identical twins, you have to dig a bit deeper to identify core differences that separate one ETF from another with the same investment philosophy and approach
The main reasons for tracking error
The first thing to do is establish what causes tracking error. There are a multitude of reasons for this but costs are typically the main one.
The ongoing charges figure, which incorporates the management fees and additional operational expenses, such as legal and auditor fees, are the main reason for a divergence in performance.
‘So by choosing a low fee option you have gone a long way to reducing your underperformance,’ Peter Sleep, senior investment manager at Seven Investment Management said.
However, it is not just fixed costs but variable fees that hack away at performance.
Additional investment costs, such as bid-ask spread – which is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept – are another major contributing factor.
The frequency of transactions often spikes in periods of high volatility which, in turn, results in a rise in the number of creations and redemption of ETF shares.
The FTSE tracker fund that charges 1%
The Virgin FTSE All Share Tracker Fund is a peculiar fund in that it charges an OCF of 1 per cent even though it simply tracks the FTSE All Share index.
To put this into context, the average actively managed proposition levies around 0.65 per cent.
The price discrepancy is wider still with comparable funds.
For example, the SSGA SPDR FTSE UK All Share ETF which returned 51.59 per cent has an OCF of 0.2 per cent.
Meanwhile, the L&G UK Index Trust tracker fund has charges of 0.1 per cent.
Here, it definitely pays to go for the cheaper option.
This results in a higher bid/ask spread and, consequently, greater tracking error.
Another source of tracking error is the witholding tax – where income tax is paid by the payer of the income rather than the recipient.
Sleep said: ‘Most indices that firms measure themselves against take this tax into account.
‘However, they usually assume a one-size-fits-all withholding tax rate of 30 per cent, but this can still cause some positive and negative difference in tracking depending on actual tax levels.’
The size of the fund can also have an impact – especially for bond ETFs.
It is very difficult to make small investments in bonds, the minimum dealing size for many bonds is often greater than $10,000, according to Sleep.
‘Consequently, in order to get a diversified spread of investments bond ETFs need to be quite big. Therefore be careful of investing in small funds.’
Too close to call: The iShare FTSE 100 UCITS ETF and Vanguard FTSE 100 UCITS ETF generated such similar returns over the past five years that you cannot pick the lines apart – choose a higher cost tracker though and you will see the difference
FTSE 100 ETF comparison
The best performing FTSE 100 ETFs are offered by the largest and second largest asset management firms in the world – BlackRock and Vanguard.
The iShare FTSE 100 UCITS ETF and Vanguard FTSE 100 UCITS ETF returned 46.1 per cent and 46.3 per cent respectively over the past five years to 26 January 2018 – less than the benchmark which grew by 47.1 per cent.
A tracker or index fund is almost always bound to slightly underperform the index due to charges, however small.
The top ten holdings of both products are comprised of the same companies and have near identical asset allocations.
There may be tiny deviations caused by slightly different portfolio management mechanics – like temporary cash holdings and cash management approach.
However, this should not result in a huge disparity in allocations and risk and returns.
When it comes to costs, the divergence is minuscule also.
Blackrock’s iShares ETF has an ongoing charges figure (OCF) of 0.07 per cent, while Vanguard’s ETF has a figure of 0.09 per cent. So in the past five years, a £1,000 investment would have grown to £1,460 through the iShares ETF and £1,461 via the Vanguard equivalent – when the OCF is deducted.
That’s a difference of a £1 – although this is likely to be more once the transaction fees are taken into account.
One key thing to note if you do look an a top ten for a FTSE tracker is that the holdings may on first glance look different, as they do with the iShares and Vanguard ETFs. The former’s top holding is HSBC, whereas the latters is Royal Dutch Shell.
However, this is due to the fact that Shell actually has two UK stock market listings with Royal Dutch Shell A and B shares. Vanguard combines the two in its top ten, with Shell at the top, whereas iShares splits them out, putting Shell in third and fidth place.
|iShares FTSE 100 UCITS ETF||Vanguard FTSE 100 UCITS ETF|
|HSBC HLDGS||ROYAL DUTCH SHELL|
|BRITISH AMERICAN TOBACCO||HSBC HLDGS|
|ROYAL DUTCH SHELL||BRITISH AMERICAN TOBACCO|
|ROYAL DUTCH SHELL||DIAGEO|
|VODAFONE GROUP||PRUDENTIAL PLC|
|PRUDENTIAL PLC||LLOYDS BANKING GROUP PLC|
How to choose between two similar ETFs
So which ETF is better? In truth, its hard to say.
Transaction costs aside, Vanguard has the higher OCF but boasts greater performance than the iShares product.
Choosing between the two funds may come down to looking at the nitty gritty and deciding whether a slightly higher weighting to, say, an oil stock is aligned to your investment approach. In truth, there aren’t many investors who are that pedantic.
Where an ETF is domiciled might tip the scales.
Investors should always seek to invest in an ETF with the term UCITS in the name, Sleep said, adding: ‘This means that the fund is invested in a way consistent with the UK and European regulations and that you have many protections in place to help prevent fraud at a fund level.
He added: ‘Ensure that the ETF has UK tax Reporting Status. This will keep the UK taxman happy and prevent you paying too much tax. You should be able to see this on the fund factsheet or website.’
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