Which Tracker?

If you wanted to buy Japanese shares last week, were you better off using an index fund or an ETF?

In the feature article we published yesterday, I described how the London Stock Exchange listings of three Japanese ETFs saw some breaks in market maker activity and exceptionally high dealing spreads in the post-tsunami period. This made trading in these funds both difficult and perilous (you risked buying or selling at a price that was significantly different from a fund’s underlying fair value).

Would it therefore have been better to use a traditional index fund to buy into Japan? Before attempting to answer that, let’s look at the prices recorded on the London Stock Exchange between Monday and Thursday last week in all three of the Japan ETFs we wrote about in our feature: IJPN, LTPX and XMJP.

The scale on the right hand side of the chart gives the percentage price move in these funds during last week from the closing price recorded at the LSE on the previous Friday, March 11.

The reason Lyxor’s fund (LTPX, represented by the magenta line) looks out of sync with the other two ETFs in the left of the chart is because it didn’t trade at all on the London Stock Exchange on Monday March 14th. The exchange recorded a closing price on that day that was unchanged from the closing price on Friday 11th. On Tuesday, mid-morning UK time, when trading in LTPX resumed, the fund’s price joined those of IJPN and XMJP in a near-15% decline from Friday’s (London) closing level.

The UK retail investor I wrote about in the feature article did get his trade done, despite a delay, late on that Tuesday morning in London, and you can see from the evolution of prices during the remainder of the week that Tuesday turned out to be a good time to buy into Japan’s equity market.

Let’s imagine that another, hypothetical European investor, also noticing the sharp decline in Japan’s share market on Monday and Tuesday last week (the Nikkei 225 index fell 6.18% on March 14 and then an additional 10.55% on March 15), decided to buy into the market using a traditional index fund.

Taking Vanguard’s Japan Stock Index fund as an example, it would have been necessary to send in a subscription agreement to the fund’s administrator by 4pm on Tuesday. The investor would then have been allocated shares in the fund based on the next day’s closing price (in Tokyo) for the Japanese shares underlying the index.

By investing only at the close of Tokyo trading the next day – and it’s impossible for an index fund to get subscription money into the market any earlier – our hypothetical investor would have missed out on the 5% rise in Japanese shares that took place on Wednesday.

This is all with the benefit of hindsight, of course, but it illustrates that there’s no easy answer to the question of whether to use an index fund or ETF.

With an ETF, you should get immediate execution, and therefore certainty as to the index level you’re investing at, but you clearly risk paying a significant spread to fair value in volatile markets. Furthermore, there’s no easy way to determine what that fair value is, particularly when the market underlying the tracker is closed (as is the case when Japanese equity ETFs are traded in European time). To get a feel of how Japan’s market is going to trade the next day you can look at the Chicago Mercantile Exchange’s Nikkei 225 futures, which trade almost around the clock, as a proxy, but these futures may not give an accurate hedge for other widely tracked Japanese equity indices, such as the TOPIX and the MSCI Japan.

With an index fund (or if you’re trading an ETF at the end-of-day net asset value, as many investors do), you’re eliminating the risk of paying a large dealing spread, but you’re also giving up certainty as to when you will be gaining the market exposure. Place an order to buy a Japan index fund in the morning European time, and you have both a full European trading day and then a full Japanese trading day ahead of you until you buy into the market.

(For the purposes of this discussion I’m ignoring structural differences between index funds and ETFs, such as the possible dilution that may occur within index funds with large cash inflows, while ETFs effectively reflect the cost of buying into the underlying shares via their own bid-offer spreads)

The extent to which you value the extra flexibility that ETFs give you depends on the kind of investor you are. If you’re investing a lump sum in the market each month, you’re probably better off with an index fund, or buying into an ETF at NAV, if that option is there. If you want to use your asset allocation skills more aggressively, then ETFs are the perfect way to do this. But, as we saw last week, you have to pay very careful attention to the price you’re getting and how your trade is executed.