(by a former ETF manager)
Let’s correct a common misunderstanding – ETFs and index funds are not the same thing. The most popular Exchange Traded Funds (ETFs) do follow index strategies but it’s similar to saying the only place you find four seats are in a car. While most cars have four seats, there are lots of dining tables out there too.
Index funds, as demonstrated by countless academics and luminaries, are the best choice for most investors, and we are strong advocates for index investing. However, holding them in an exchange-traded format depletes some of their potency and the total investor return.
There are three main reasons: tax, trading cost and drag.
Tax efficiency is the often assumed but rarely found aspect of funds management. Often, ETFs investing internationally end up not claiming all the tax credits, treaty benefits and refunds due to them because it is hard work and has an immaterial benefit to the ETF manager. That means you as an investor miss out.
NZ ETFs are classified as a listed PIE, meaning that each distribution from the fund is automatically taxed at 28% – the highest rate. Therefore, any investor with a lower PIR pays too much tax, which they can’t request back from the IRD until the following May via a tax return (assuming they have other taxable income they can offset against).
Furthermore, the ETF practice in NZ is that the tax is deducted from the distribution immediately and sits as cash within the fund, not eligible to be distributed to investors or invested in the market. An unlisted index fund, however, avoids both these issues. The tax is deducted at the correct rate at the earlier of the selling of units or the following April.
In other words, the money owed in tax can be used by the fund and the investor in the meantime, and distributions paid are higher as they are gross of tax, with the tax paid separately.
The second main reason is higher trading costs, granted with an ETF there is the benefit of choosing exactly what price to buy or sell for. However, the average brokerage rate in NZ for many investors is somewhere between 0.20% and 0.70%. This is a significant cost, especially if you are wanting to regularly invest into the fund.
Additionally there is the market spread, usually either side of the unit price, and an often forgotten extra cost or deviation from the underlying price (a ‘spread’ is the difference between the price you can buy the ETF units on market for vs the true value of the units).
With an unlisted index fund such as Kernel’s, there are no brokerage, price spreads or registry fees. This makes it more efficient when implementing a portfolio decision or regularly investing. ETFs, meanwhile, appeal to institutional investors who think in million dollar amounts with corresponding negotiating power with market makers and where the short term “equitization” of idle cash is the goal. This underpins the high-frequency high volume of the S&P 500 tracking VOO and SPY exchange traded funds.
The enemy of vehicle designers and index fund managers alike. An index, such as the S&P/NZX 20 index, is fully invested at all times, however, in reality for an index fund there is often a small amount of cash in the fund, used to manage the fund’s cash-flow and expenses. Therefore, every dollar in the fund that is not invested, drags the performance comparative to the cashless index.
In a normal and long-term upward moving economy, this is a negative effect. In an ETF, the above mentioned tax payment and also the dividends paid by the companies in the fund, sit as cash until payment or distribution (often months), which drags the performance of the ETF units vs the actual performance of the index. Kernel does not do this, and is able to be more than 99.9% invested at all times, giving the investor the closest return to the index.
Finally, any fees paid to the fund manager eat into investor returns, and while efficient and quality operations do have a cost, not being listed avoids the listing fees and registry fees which would increase the management fee on the fund.
So while management fees are important, for both ETFs and index funds, Kernel is also focused on the subtleties to maximize the net returns for you, our investors.
Good fund design, coupled with great indices that have proven value over time, will give you a better return.