What you need to look at before investing in a tracker fund or ETF

Picking an index to track is just the first of several analytical decisions ETF investors must make when choosing a fund.

The growth of the exchange traded fund market is relentless. There are already close to 2,300 products on sale to UK investors, which provide all sorts of market exposures. And the number of ETFs on offer is set to increase, as both long-established players and asset managers looking to enter the ETF space fight for a slice of the pie.

Few can dispute the benefits – chief among them low cost – that ETFs bring to investors. However, product proliferation is making the task of ETF selection rather daunting.

Cool judgement called for

Investors are constantly required to scrutinise closely and compare against each other the numerous investment propositions on offer to ensure they pick those that meet their specific needs. However, when selecting ETFs, there isn’t the same room for the subjective judgments that help investors pick active funds.

When choosing an active fund, we ultimately place our trust in the abilities of the people running a fund. Our choice may prove ill-fated, but it is easy to justify why, for example, one would pick a fund based on the favourable public profile of its manager.

However, the human element doesn’t help in the ETF selection process. We may have views about specific ETF providers, but we are unlikely to be able to name an ETF manager. The ETF management process is highly automated, so investors are called on to try to make cold, fact-based calls.

In particular, they must pay close attention to the index that a prospective ETF investment tracks, as that defines the investment proposition. The selection process doesn’t end with the choice of an index, though. Other factors at play must be considered, as these can lead to marked variations in the relative performance of ETFs – even ETFs tracking the same index.

Let’s look at the group of ETFs listed on the London Stock Exchange that track the S&P 500 index (see tables). They all have the same investment strategy, one worthy of a Morningstar analyst rating of gold. This rating conveys strong conviction on the part of Morningstar analysts in the merits of the S&P 500 index-tracking funds in performance terms, relative to the average of their peer group (which includes active funds) in the Morningstar US large-cap blend category over the long term.

S&P 500 ETF charges

Name Domicile Replication  KIID ongoing charge (%)
Amundi IS S&P 500 ETF Luxembourg Synthetic 0.15
HSBC S&P 500 ETF Ireland Physical 0.09
Invesco S&P 500 ETF Ireland Synthetic 0.05
iShares Core S&P 500 ETF    Ireland Physical 0.07
Lyxor S&P 500 ETF Luxembourg Synthetic 0.15
SPDR® S&P 500 ETF Ireland Physical 0.09
UBS ETF S&P 500 Ireland Physical 0.12
Vanguard S&P 500 ETF Ireland Physical 0.07
Xtrackers S&P 500 Swap ETF  Luxembourg Synthetic 0.15

Source: Morningstar Direct, as at 1 March 2019.

But the S&P 500 ETFs listed on the London Stock Exchange differ in price, domicile and replication method, so which might be best for you? That’s a question only you can answer.

Returns from these ETFs over one, three and five years (see table below) have beaten the Morningstar category average, supporting the idea that investing in the S&P 500 index has, on the whole, proved a good strategy for investors in US large-cap equities. However, the ETFs that replicate the index synthetically have typically delivered higher returns than those that replicate it physically, primarily because swap-based ETFs can avoid paying withholding tax on US stock dividends (15% for Irish-domiciled and 30% for Luxembourg-domiciled stocks), whereas physical ETFs can’t.

S&P 500 ETF total returns

Name Replication  TR 1yr (USD)  TR 3yrs (USD)  TR 5 yrs (USD)
X S&P 500 Swap ETF Synthetic 4.61 15.18 10.47
Lyxor S&P 500 ETF Synthetic 4.47 15.11 10.43
Invesco S&P 500 ETF Synthetic 4.59 14.98 10.33
iShares Core S&P 500 ETF Physical 4.30 14.86 10.26
Amundi IS S&P 500 ETF Synthetic 4.48 14.95 10.25
Vanguard S&P 500 ETF Physical 4.26 14.83 10.24
HSBC S&P 500 ETF Physical 4.45 14.85 10.22
SPDR® S&P 500 ETF Physical 4.28 14.81 10.22
UBS ETF S&P 500 Physical 4.25 14.80 10.19
EAA Fund US Large-Cap Blend Equity sector   2.51 13.02 7.95

Note: ETFs ranked by five-year return. Source: Morningstar Direct, as at 1 March 2019.

Complex picture

This doesn’t mean that a synthetic ETF is always a better choice, however. Investors concerned about swap counter-party risk, for example, may find that a physical ETF fits their profile better.

Price would be a good selection guide, as would fees, which eat into returns. But again, choosing is not that simple. Some providers of physical ETFs engage in securities lending. The proceeds from this practice may partly offset their ongoing charges. Nevertheless, some investors are unwilling to take on the risk entailed when fund holdings are lent out. Selection may ultimately come down to personal requirements in terms of dividend treatment, availability on platforms or trading currencies.

Selecting ETFs is complex. The starting point is choosing an index that reflects the market exposure you want, but there are other factors to consider, and as the number of ETFs available grows, the selection process will only become more difficult.

Jose Garcia-Zarate is associate director of ETF research, EMEA, at Morningstar

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