Why have ETFs not caught on in the UK?

In the same way that US political and cultural trends often spread overseas, so, too, do America’s most popular investments. But, in the UK, investors have been much slower to embrace one of the most successful exports of all: the exchange traded fund.

In the US, ETFs have gained a rapidly increasing share of the sums allocated to funds, with many asset managers looking to convert so-called mutual funds into ETF structures. US ETFs even have something of an icon in the form of high-profile fund manager Cathie Wood.

However, the explosive uptake of ETFs has not been repeated on the other side of the Atlantic. Lipper data shows that the average traded value for ETFs in September on the London Stock Exchange was £8.03bn, which accounts for roughly 10 per cent of total average daily turnover. That contrasts with the US, where ETF trading accounted for a record 30.7 per cent share of market turnover in 2022.

Among the reasons ETFs have not broken through in the UK — despite the popularity of their passive, index-tracking, investment strategies — are the lack of tax advantages that they enjoy in the US, and the recent worries about their pricing at times of stress. When markets plunged in March 2020, as the Covid pandemic spread, the prices of some corporate bond ETFs dropped significantly below their net asset value.

But by far the biggest reason for slower take-up is the continued dominance of, and easier access to, traditional UK fund structures.

UK managed funds tend to take the form of open-ended investment companies (Oeics) or unit trusts, which investors can buy directly. ETFs, by contrast, issue shares that can only be traded on the stock market — which can cause several frustrations for UK investors looking to buy in.

First, many investment platforms levy dealing charges on ETFs, while the buying and selling of many other funds is free. This can reduce the appeal of ETFs, even if some platforms charge lower annual fees to an investor holding ETFs rather than traditional fund.

Second, investing can simply be clunky. “Many platforms are antiquated and still struggle to efficiently trade ETFs . . . [they] are more suited to fund trading,” notes Lynn Hutchinson, passive investments specialist at wealth manager Charles Stanley. “Ever since I have been involved in ETFs, there has been talk about platforms requiring work to make the trading side more efficient, but the problem seems to persist.”

Third, many platforms still fail to offer fractional share trading of ETFs, whereby investors can buy a portion of a share at a time, committing smaller sums of money. That means investors have to hold cash until they have enough money to buy a full share.

Finally, ETFs in the UK face stiff competition. The alternatives can be extremely competitive on price, and offer much the same as the older ETFs in terms of tracking a specific index. “For the vast majority of investors, ETFs are identical to [traditional] tracking funds,” argues Peter Sleep, senior investment manager at Seven Investment Management. “There’s no reason to buy ETFs.”

However, despite the downsides to ETF investing in the UK, there are reasons to believe the tide could turn — gradually.

Goncalo Machado, a manager at ETF investing platform InvestEngine, admits that technological limitations will continue to deter UK investors from putting as much money into ETFs as their peers in the US. But he adds: “As the investment and platform industry evolves, and costs of ETF execution become more streamlined, the market share of ETFs should increase.”

He believes the rise of newer trading platforms — including InvestEngine, which specialises in ETFs — could help spur such improvements. 

In addition, the legacy of the pandemic-era boom in trading could also favour ETFs, which can be bought and sold much more quickly than other funds. And the newer funds that are likely to appeal to younger investors — for example, thematic portfolios focusing on areas such as clean energy — also tend to be available mainly in an ETF format.

There are already some signs that ETFs are already taking off among younger British investors. Interactive Investor, the UK’s second-biggest DIY investment platform found that, among its customers, those aged between 25 and 34 had just under 14 per cent of their money in ETFs at the end of June, while the 35-44 age group had on average around 15 per cent. That compares with 4.2 per cent in ETFs for those aged 65 and older. These demographics suggest ETFs in the UK will continue to make gains.