Demand for passive investing shows no sign of slowing down, as the money flowing into exchange traded funds and index tracker funds continues to hit new highs.

In the first three months of 2012 net retail sales of tracker funds reached a record £661 million. And in the ETF space, the number of ETFs listed in Europe has hit 1,304. This compares with just 273 ETFs on offer in 2006, according to BlackRock.

For investors that have decided to ditch active and go passive, the choice boils down to exchange traded funds or traditional indexed funds.

Both types of fund track the market – following it up during rallies and down when the market crashes – and both are low cost compared with actively managed investment funds. ETFs tend to be cheaper, although the difference in price has narrowed as annual management charges for passive mutual funds have fallen.

According to Morningstar, the average total expense ratio for UK-listed ETFs is 0.47 per cent. The average TER for a tracker fund is 0.64 per cent.

An ETF and a conventional index fund tracking the same index have broadly similar risk and return attributes, holdings and portfolio turnover. Vanguard, which offers mutual tracker funds and ETFs in the UK, says the main difference between the two lies in the investment flexibility they offer.

ETFs are traded on stock exchanges, which means the stock market updates ETF prices continually during the day, and investors can trade them frequently.

Conventional index funds, on the other hand, are bought directly from a fund management company. They are priced once a day at net asset value, in the same way most actively managed funds are.

Investors wanting maximum flexibility – to buy and sell the fund many times in one day, and even short sell and put stop, limit or open orders on investments, for example – will find ETFs the most suitable vehicle.

A report by Vanguard states: ‘Because ETFs can be sold at any time during market trading hours, they can be used to implement speedy and tactical portfolio changes, as a ready source of capital for investment in some other form of security or simply to cover unexpected liquidity needs.’

It says an investor would typically buy a conventional index fund because he or she ‘has access to conventional index funds that are competitively priced relative to comparable ETFs; makes only periodic investments or redemptions, rather than trading on an intraday basis; and does not require the investment flexibility associated with ETFs’.

ETFs also cover a wider range of indices. Timber and forestry, clean energy, Vietnam and global infrastructure are just some of the more esoteric ETFs on offer.

In short, ETFs tend to be cheaper and more flexible, and cover a bigger variety of sectors. But that doesn’t mean they are better. The ETF is arguably a more complicated beast than its older tracker fund cousin.

Conventional tracker funds are structured as unit trusts or Oeics, so investors used to dealing with open-ended funds will find them easier to understand.

ETFs come in two flavours: physical and synthetic. A physical ETF holds all, or a representative sample, of the constituents of an index, just like a traditional tracker fund. HSBC, iShares and ETF Securities use this approach for most of their ETFs.

Synthetic ETFs buy a swap, which means entering a contract with a counterparty that promises to pay the total return of the chosen index as cash. Lyxor and db x-trackers mainly offer synthetic funds.

The advantage with this approach over physical replication is that an ETF can normally track the index more closely and more easily track trickier indices such as the Chinese stock market. However, the Financial Services Authority has warned that investors need to better understand the counterparty risks of synthetic ETFs.

Most financial advisers use both tracker funds and ETFs to gain passive exposure for clients. They might use an ETF for exposure to Brazil and a mutual fund to track the FTSE 100, for example. However, advisers say investors should look closely at charges, as ETFs aren’t always cheaper – the HSBC FTSE 100 Index fund has a TER of 0.27 per cent, while the HSBC FTSE 100 ETF has a higher TER of 0.35 per cent.