What is an ETF? How do they work? and why do they beat Active Fund Managers?
Back in January, the US Securities & Exchange Commission (SEC) gave the green light for the sale of ETFs linked to Bitcoin’s spot price. This news sent waves of excitement across the country, especially among those who’ve been eyeing the explosive growth Bitcoin has shown in the past. The idea of combining Bitcoin’s potential with the accessibility of ETFs caught the attention of many investors—especially those who aren’t exactly tech wizards.
But for a lot of people, this headline raised a big question: What exactly is an ETF?
Exchange-traded funds, or ETFs—sometimes called ‘trackers’ or ‘passive funds’—are a go-to choice for investors aiming to build a diversified, low-cost portfolio. These funds come in all shapes and sizes, tracking everything from market indices to specific asset types or even entire investment strategies, each with its own level of risk.
Advocates for more expensive, Actively Managed funds often dismiss passive ETFs, calling them an investment vehicle for ‘guaranteed mediocrity.’ Much to their chagrin, mountains of research show that, over the long haul, these so-called ‘mediocre’ ETFs tend to outperform their active counterparts. We’ll dive into that a bit later, but first let’s take a look at what an ETF is.
What is an ETF?
ETFs give investors a ticket to explore a world of markets, usually at a bargain price. Most ETFs are passive investments, which means they simply aim to mirror the performance of a specific group of investments—no fancy footwork, just straightforward tracking. Where investors were previously constrained to buying individual assets or paying hefty fund fees, ETFs gave them exposure to a broad basket of assets at a low-price.
Contrary to this, actively managed funds are all about trying to beat the market, and that means higher fees to cover the cost of a whole team of analysts working behind the scenes.
To put this in perspective, the ongoing charge for the iShares Core FTSE 100 ETF, a popular tracker of the FTSE 100 index, is a mere 0.07%. But if you go with an actively managed fund, you’re looking at ongoing fees that range from around 0.75% to over 1.25% of your total investment each year. It might not seem like much in a single year, but those extra costs can demolish returns over time.
Why are ETFs popular?
To many investors, Passive investing sounds like watching paint dry when compared to active share selection and fund manager outperformance, sometimes referred to as Alpha. However, studies show that, once you factor in costs, the average active fund manager actually underperforms against the market. So, unless you can pick a manager who consistently outshines the market—which is easier said than done—it might be worth considering the lower-cost option of a tracker like an ETF.
ETFs also make it easy to build a diversified portfolio. Since they’re listed on the stock exchange, you can buy and sell shares in them just like any other company. Meaning you can quickly and easily build and rebalance your portfolio as needed.
ETFs are like chameleons—they’re great at mimicking whatever market or asset you want to track. Let’s say you’re eyeing Japan’s stock market. The XTrackers Japan ETF is designed to mirror the performance of select Japanese companies, making it a solid choice if you want your portfolio to reflect what’s happening in Tokyo.
But ETFs aren’t just about stock markets or indices—they can track specific assets too. If you’re Interested in commodities like oil, gas, or precious metals, ETCs, or exchange-traded commodities, can come into play. If you’ve got a hunch that oil prices are going to rise, the WisdomTree Crude Oil ETF can help you capitalize on that by tracking the commodity’s price.
ETFs can even dive into investment themes or strategies, no matter how niche or futuristic they might be. Their flexibility has given rise to some pretty unique options over the years. Take for instance the Procure Space ETF. Trading under the ticker ‘UFO,’ it’s for those who believe the outer space economy is the next big thing. If you think the stars align for space exploration profits, this might just be your ticket.
How do ETFs work?
So, how do ETFs actually work? There are two main types: Physical and synthetic.
Physical ETFs keep it simple—they invest directly in whatever they’re tracking. If you’re investing in an S&P 500 tracker, the ETF buys shares of the companies that make up the S&P 500 Index. A Copper ETF (or ETC)? It’s backed by physical copper sitting in storage somewhere. But when you invest in an ETF, you’re buying a stake in the ETF itself, not in the index or the actual assets it tracks.
Then there are tech-savvy providers that offer ETFs through ‘sampling’ or ‘optimization.’ Instead of holding every single asset in a market, they use algorithms to pick a representative sample that mirrors the overall market. This approach aims to cut down on the costs associated with full replication, potentially saving you money in the process.
Synthetic ETFs are a bit more complex. Instead of holding the actual assets, they buy derivative contracts, based on the asset or index. These derivatives promise to deliver the same returns as the index or underlying investment they track. This approach allows you to invest in markets that might be tricky to access otherwise, like stock markets with tight restrictions on foreign investors or soft commodities.
Physical ETFs are generally easier to understand and come with fewer hidden risks, making them a better fit for most individual investors. However, you may lean towards synthetic ETFs because they offer the potential for a lower ‘tracking error’—don’t worry, we’ll get into that in just a bit.
The downside of ETFs
ETFs are a hit with investors of all stripes, and it’s easy to see why. But just because they’re popular doesn’t mean they’re flawless.
Yes, ETFs are generally cheaper than options like conventional funds or Unit Trusts, but they’re certainly not free. Since ETFs are traded on the stock exchange, like individual shares, you will need to pay a broker to make the trade happen. These dealing charges can range from £5 to £12, and you’ll have to pay them every time you buy or sell shares. If you’re someone who likes to buy in small amounts over time, those fees can pile up fast and start eating into your returns.
Even though ETF managers aim to keep their fund’s performance in line with the objective it tracks, it’s not always a perfect science. An ETF can drift from its intended benchmarks for various reasons. When this happens, the ETF might not perfectly mirror the index, leading to what’s called a tracking error. This means the ETF’s returns could differ from the index or assets returns. Fortunately, these deviations are usually minor and tend to correct themselves over time. Investors can pay a premium for synthetic ETFs to potentially reduce this risk.
Because many ETFs track a benchmark index, they’re not designed to outperform it. ETFs aim to match the market, not beat it. After fees, an ETF will in most instances return marginally less than what it tracks. This is where the term ‘guaranteed mediocrity’ comes into play.
Unfortunately, any gains made on an ETF are liable to Capital Gains Tax, like any other share. Unless you’re holding an ETF within an ISA, pension or tax wrapper, the taxman will take a bite of any gains. Unlike shares, stamp duty reserve tax is waived for purchases of ETFs in the UK.
Why do ETFs outperform Actively Managed Funds?
So, which one puts more cash in your pocket: Passive ETFs or actively managed funds? You might assume that a professional money manager could easily outshine a basic ETF tracker, but that’s not the case. Study after study, spanning decades, reveals a disappointing truth—active fund managers often fail to simply outperform their benchmark index.
Take 2022 as an example: S&P Global found that a whopping 92% of actively managed UK equity funds and an even higher 97% of UK large and mid-cap equity funds underperformed their benchmarks. And that’s not just a fluke—it’s a consistent trend across the globe.
But it’s not just about underperformance. Even when active funds do manage to match or beat their benchmarks, the hefty fees they charge can seriously erode any potential gains over the long haul. So, despite the allure of a seasoned pro managing your money, passive investing often comes out on top.
That said, it’s not always a clear-cut case of passive beating active. Actively managed funds do have their place, especially depending on an investor’s specific circumstances. Some investors are willing to pay those higher fees for the expertise of an active manager, particularly in times of market volatility or wild price swings.
This is why many advisers opt for a blended strategy, leveraging the strengths of both approaches. Often, they use a ‘core and satellite’ approach—where ETFs and other passive investments form the bulk of the portfolio, and actively managed funds are used to add a bit of extra flavour. This strategy can help smooth out the bumps during volatile periods, ultimately paying a fund manager to manage an investors risk in the shorter term.
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