Is an ETF really cheaper? What you need to know

Exchange-traded funds (ETFs) are a popular way for investors to access the market, but there is still a lot of confusion around what they really are, especially in comparison to a traditional tracker fund.

While ETFs and traditional tracker funds (an open-ended fund) play a similar role investments-wise, they are considered differently in terms of regulation. While this might not sound like the most exciting difference, understanding the intricacies can help you maximise your returns.

You can think of an ETF versus a traditional fund like different wrappers on a sandwich. One is aluminium foil, one is paper, but they both hold the same sandwich inside. ETFs are primarily used to follow an index, although there is a small group of them now that are being used for active funds. The ETF ‘wrapper’ means that it is traded like a stock. It can be bought and sold throughout the trading day, while a traditional fund is only traded once a day.

How are ETFs taxed versus traditional funds?

There are a lot of misconceptions around how ETFs are taxed, and when you’re researching this, it’s important to make sure you are looking at the UK rules. For both ETFs and traditional funds, you can still be liable for capital gains tax and income tax if they are held outside of a tax-efficient wrapper like an ISA or pension.

There are other advantages to holding an ETF in the US and some parts of Europe which make them a much better option than traditional funds that are not relevant to the UK.

Although ETFs are traded like shares, they do have an exemption from stamp duty, which is the 0.5% tax charged when you buy or sell shares. Traditional funds are also exempt from this tax.

What are you charged for buying and selling?

For AJ Bell investors, this is where ETFs and traditional funds start to differ. Traditional funds have a dealing cost of £1.50 per transaction, while ETFs have a dealing fee of £5. However, if you deal more than 10 times in a month, this fee goes down to £3.50 per transaction. Both ETFs and traditional funds are eligible for regular investing, which would mean that the once-per-month investment was free from dealing charges if it was over £25.

However, there’s also account charges to consider. Account charges on shares are 0.25% annually, with a maximum of £3.50 each month. So, if you had £250,000 in ETFs in your account, you’d only pay £42 each year in account charges. Meanwhile, if you held £250,000 in funds, there is just the 0.25% fee with no maximum, so you’d pay £625 in account charges. The 0.25% fee decreases to 0.10% after £250,000, and to no charge after £500,000. You’d only be able to have £16,800 in funds before ETFs became cheaper, if you used regular investing and made no other trades.

If you are someone that trades more often, it’s worth playing around with the charges calculator to see which way of investing would be more efficient for you.

Investment costs

If an ETF or traditional fund has a lower ongoing charge will likely differ on a case-by-case basis. For example, the HSBC FTSE All-World Index fund has an ongoing charge of 0.13% while the Vanguard FTSE All-World UCITS ETF, tracking the same index, has an ongoing charge of 0.19%. For people who plan to invest a larger amount of money, the differences here might be outweighed by the account charges described above.

It is worth knowing that ETFs have a bit more flexibility in how they can manage their assets, and this will sometimes give them a boost over the traditional fund version. This includes the synthetic ETF structure, where the fund agrees to swap contracts with an investment bank to get the return of a specific index minus fees, instead of buying each of the investments. This can mean savings on trading costs and taxes, which benefits the ETF in the long term. In addition, the fact that ETFs are traded on a market instead of funds constantly moving in and out creates a simpler flow of money for managers to handle. These methods don’t always beat out a traditional fund, but they are some reasons why people might favour them.

Which is really better?

The most efficient vehicle for you will depend on what you’re trying to purchase, how much of it, and at what frequency. Some investments will only be offered in a traditional fund version, or in an ETF version, but for funds tracking major indices, there’s often options in both. If you plan to trade your investments often, the charges of an ETF could stack up. Equally, if you plan to invest large sums, the limit on ETF fees can be helpful. If you’re comparing performance of an ETF and traditional fund, don’t forget to factor your other charges into the calculation.