Exchange-traded funds and how they differ

Exchange-traded funds hold the same kinds of assets as conventional funds and are bought and sold differently, which changes several practical things.

The structural difference

How they work.

A conventional fund is bought from and sold to the fund provider at a price calculated once a day.

An exchange-traded fund is bought and sold on an exchange throughout the day, at whatever price the market offers.

A creation and redemption mechanism involving authorised participants keeps the market price close to the underlying value, which generally works well in liquid markets and can break down in stressed conditions.

Which means an ETF can trade at a premium or discount to its underlying value, generally small and occasionally not.

The costs that differ

Beyond the ongoing charge.

The bid-offer spread, which is the difference between the buying and selling price and which is a real cost incurred on every transaction.

Dealing commission charged by the platform.

Which means frequent small purchases in an ETF can incur costs that exceed the saving from a lower ongoing charge, particularly for regular monthly investing.

Some platforms offer commission-free regular investing in selected ETFs, which changes the calculation.

And currency conversion where the ETF is denominated in another currency, which can be a substantial margin.

Where ETFs are advantageous

Genuine benefits.

Lower ongoing charges in many cases, particularly for broad index exposure.

Access to asset classes and markets not easily available otherwise.

Intraday liquidity, which matters for some investors and not for most long-term ones.

Tax efficiency in certain jurisdictions arising from the structure.

And transparency, since holdings are generally published daily.

Where conventional funds are simpler

For many retail investors.

No spread and no dealing cost in many platform arrangements.

Straightforward regular investing and automatic reinvestment.

Fractional investment, so the whole contribution is invested rather than leaving a residue.

No intraday price to watch, which removes an invitation to trade.

And simpler for anyone who does not want to think about execution.

Which means the right choice depends on the platform, the amounts, the frequency and the investor.

The behavioural problem

Worth stating plainly.

Intraday tradability makes trading easy, and research consistently finds that more frequent trading is associated with worse net returns for retail investors.

Studies of the behaviour gap generally find it largest in the most tradable and most specialised products.

Which means the feature that distinguishes ETFs is also the feature most likely to cost the holder money.

An investor who buys a broad ETF monthly and never looks at it captures the cost advantage; one who trades it does not.

The products to be careful with

Within the category.

Leveraged and inverse products, which are designed for short holding periods and which decay over time due to daily rebalancing — holding them for months produces outcomes that surprise people who expected a multiple of the index return.

Thematic and narrow sector funds, which are frequently launched after a theme has performed well and which have a documented tendency to attract money near peaks.

Synthetic products where the replication method is not understood.

Exchange-traded notes and commodities, which have different legal structures and different risks from funds.

And very small or newly launched funds, which may close, forcing a disposal at an inconvenient time.

Practical execution

If you buy them.

Avoid trading at the open and close, when spreads are typically wider.

Check the spread before dealing.

Use limit orders rather than market orders for anything other than the most liquid funds.

Prefer funds with substantial assets and trading volume, which generally have tighter spreads.

Check whether the fund is domiciled somewhere with favourable tax treatment for your residence.

And check whether it is accumulating or distributing, and whether that suits your account.

The choice in practice

A reasonable summary.

For a long-term investor making regular contributions on a platform with dealing charges, conventional index funds are frequently simpler and cheaper in total.

For lump sums, larger portfolios, or platforms with commission-free ETF dealing, ETFs are frequently cheaper.

For most people the difference is small relative to the difference between a low-cost fund and an expensive one.

And the wrapper matters considerably less than what is inside it and how long it is held.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.