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3 Ways Not All ETFs are the Same

Price, process and index variations all differentiate ETFs from one another

Hortense Bioy, CFA 27.11.2014

The choice to use ETFs rather than actively managed funds is a significant one, to be sure. And while actively managed funds may come in more varieties in terms of fund characteristics, strategies, and so on, ETFs also have their differences, though some are more obvious than others.

Cost Still Counts
Among the biggest differences with ETFs is the fees they charge. ETFs that are otherwise virtually identical--meaning they track the same index--can nonetheless produce different returns based on their fees. That's because fund fees are deducted from fund returns. So assuming two identical portfolios, the fund with the lower fees, and therefore the smaller bite taken out of returns, will tend to deliver a higher total return to investors. (Some ETFs also may lend out some of their holdings to generate income for the fund and thereby lower their total fees, but with it comes also counterparty risk.)

The Challenges of Tracking an Index
Although expense ratio is usually by far the most significant difference among ETFs tracking the same index, there may be others as well. Among these is the extent to which the ETF tracks its index. For example, the managers of an ETF tracking a small-cap index that includes micro-caps--stocks of very small companies that can be hard to buy--may decide it's not cost-effective to try to own each and every stock in the index. Instead they may employ a technique known as optimisation or sampling, in which the portfolio is designed to mimic the performance of the hard-to-buy stocks, using similarly behaving liquid stocks in their place. Optimisation and sampling techniques can vary from fund to fund and may contribute to mis-tracking.

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About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  Hortense Bioy, CFA, is Director of passive fund research for Morningstar Europe.

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