June 22, 2021

Keeping Track

by Dewi John.

Tracking Error, Cost, Sector Ranking, and ESG Exposure: What the IA’s Passive ETF Inclusion Offers Investors


ETF additions to Investment Association sectors have a lower tracking error to major market benchmarks than existing passive incumbents. They also give access to some niche passive strategies and compelling ESG and new technology plays.


We recently analysed the broad effects of adding 531 ETFs to the IA sectors, with assets totalling £383.2bn. In this article, we look at how this affects the choice of passive funds in certain key sectors. The admission of ETFs has significantly expanded the choice of passive instruments in the three most impacted sectors: there are now 12 passive mutual funds and 50 passive ETFs in North America; and 26 and 56, respectively, for Global. Some 71 passive ETFs have been added to Specialist—the most of any sector—where there are no passive mutual funds.[1]


Many Benchmarks

Despite both Global and North America having most new ETFs, the broad range of benchmarks in each sector means that, even for the most common indices such a MSCI All World or S&P 500, there isn’t a large sample size when comparing funds using the same benchmark. However, there are two ETFs and two passive mutual funds benchmarked to the S&P 500 TR.

The average total expense ratio (TER) for ETFs is 0.08%, and tracking error, 0.09; the stats for passive mutuals are 0.125% and 0.67, respectively (see table 1). This is in line with the earlier analysis we performed on UK All Companies funds. Therefore, on the most used benchmarks, ETFs have a better tracking error and are cheaper (excluding dealing costs) than their passive mutual equivalents.


Table 1: Total Expense Ratio and Tracking Error—ETFs v Mutual Trackers

Source: Refinitiv Lipper 

For both sectors, sterling share classes dominate for mutual funds, while dollar (with a smattering of euro share classes) are more prevalent in the ETF world—unsurprising, given that ETFs are a more international product, all of which are listed outside the UK.Source: Refinitiv Lipper, Primary Share Classes, data to 31 May 2021

While the TERs for Global ETFs are higher, they also cover more esoteric indices. For example, the L&G Cyber Security UCITS ETF, with a TER of 0.75%, tracks an index of public companies involved in providing cybersecurity technology and services, while the L&G ROBO Gl Robotics and Automation UCITS ETF (TER, 0.8%) seeks to replicate a global robotics and automation index. There’s no Global mutual fund tracker with such a niche remit, so it’s hard to say how competitive they are—it’s a small field, in which ETFs are the top (because only) dogs. Other strategies on offer include a range of S&P 500 industrial sector ETFs from iShares in North America, and specific country funds from various providers in Specialist.

When it comes to tracking major indices, it seems that ETFs offer a better match than their mutual fund peers. The message on costs isn’t so clear—especially given that dealing costs for ETFs can’t be factored in—but the move opens a range of interesting and granular passive strategies for investors.


Giving No Quartile

One other potential affect of ETF inclusion is the skewing of IA quartile membership. Other than the impact on the occasional active manager’s bonus, why is this relevant? It can impact funds that may be selected for client portfolios if, for example, first-quartile membership over a specific period is stipulated in a platform model. That wouldn’t be a problem—just swap out a mutual fund for an equivalent ETF—if those same platforms support investment vehicles traded on an exchange. Which many don’t. So, it could have negative impacts on fund selection.

We therefore looked at the effects of ETF inclusion on the membership of the top quartile over 12 months in the two sectors with the greatest number of ETF incumbents (excluding Specialist)—North America and Global—plus UK All Companies.

With Global, there’s no change in top-quartile non-ETF membership; with North America, one mutual fund gets pushed into the top quartile that otherwise wouldn’t have made it; and with UK All Companies, there are two mutual funds in the post-ETF inclusion top quartile that wouldn’t otherwise be there. So, the effect overall on the top-quartile mutual fund universe is to broaden it.

While we’ve not extended this analysis to the quartile spread of ETFs in the three sectors, it seems likely that what’s driving this distribution is:

  • For UK and North America, most ETFs are benchmarked to some variant of the S&P, FTSE, MSCI, Russell, etc., therefore increasing the bulge around the mean (and so ETFs tending to cluster in second and third quartiles).
  • A far more diverse range of indices in Global, which produces a more even spread, and so little overall change.


Babushka, Babushka…

It’s worth bearing in mind that this is a snapshot, and won’t be ever thus. For example, much Global sector performance has been driven by large-cap growth and tech: “Perfect for tracking funds and smart beta ETFs,” notes Richard Philbin, Chief Investment Officer at Wellian Investment Solutions. Tracker funds with such biases will do well in the low-interest rate environment that’s characterised the post-Global Financial Crisis world.

This is also true at the country level: for instance, the US has a bias to large-cap growth stocks. “So, if the US has done well due to index movements, it will be a bigger part of the World Index weight. The constituent countries will feed into the world,” adds Philbin. “Just think of the Russian doll effect in reverse,” where the US is one stage smaller than the outer total-world babushka. If you get a style reversal affecting such major components, such as a return to higher rates and higher inflation, he says, this could lead to a significant reshuffling of the deck (the mixed metaphor is mine, not his).

The IA-included ETFs that have performed strongest over the past three years, however, have been those with an ESG or new energy tilt, as can be seen from the table below. Indeed, the iShares Global Clean Energy UCITS ETF USD (Dist) leads the sector over the period, not just its ETF cohort, with a 128.7% three-year return.


Table 2: Top-Quartile Global ETFs Over Three Years (%)

Source: Refinitiv Lipper, Primary Share Classes, data to 31 May 2021


This broadened universe clearly presents a bigger—or, rather, fuller—toolbox for those investment professionals determining their investment universe through the IA criteria. While that’s a net positive, there’s no consensus that this is the best way to categorise funds, as Kerry Nelson, founder at Nexus IFA and Nexus Investment Managers, argues. “IA sectors are a bit of a blunt instrument by which to benchmark performance. Advisors are used to it, and many DFMs simply go along with advisors. But as an industry, we need to be educating investors about the advantages of more specific benchmarks.”

Across many metrics, investor needs are shifting to greater sophistication and granularity. Fortunately, we have a solution.



Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

[1] Calculated based on Lipper Primary share classes. Using all share classes, all Global results are the same, as are the North America mutual trackers, with the NA ETF average TER and TE being 0.215 and 0.37 respectively

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