Exchange traded funds vs passive mutual funds
One of the big debates about investment fund charges is whether exchange traded funds are less expensive to run than equivalent mutual fund trackers.
To find out, we asked Morningstar to compare the data for five categories of purely passive funds by taking the asset-weighted average of the annual total expense ratio (TER) of every passive fund.
It found that ETFs are considerably cheaper than passive mutual funds in most cases. The differences revealed are larger than one might expect, particularly in large liquid equity markets, such as eurozone large-cap funds, where the average passive mutual fund charges 0.63%, compared with 0.23% for the ETF equivalent.
Many financial advisers, however, maintain that mutual funds are cheaper, particularly for UK equities. While there are some popular cheap-ish traditional trackers, such as L&G's UK Index fund, which carries a TER of 0.55%, compared with, say, iShares FTSE 100 ETF, which has a TER of 0.4% flat, the inescapable conclusion is that this common adviser claim is largely driven by which funds pay commission to advisers.
Mutual funds in emerging markets
Where mutual funds are almost always cheaper, however, is emerging market equities. That's because relatively few emerging market equity funds are available to retail investors, so the average fees are generally similar to those paid by institutional investors.
"Overall, in all these categories, the fewer the retail-focused tracker funds and the more institutional-focused, the smaller the difference between tracker funds and ETFs in terms of TER," says Hortense Bioy, senior ETF analyst, fund research at Morningstar Europe. "Ultimately, what ETFs do is they bring institutional-level pricing to retail investors."
The difference in fees between UK and euro large-cap equity ETFs reflects the eurozone's scale.
"It is a bigger market," adds Bioy. "There is more money and it's more competitive, especially with the new entrants breaking into the market and the multiple cross-listings.
"Stamp duty in the UK can also explain the difference between UK and euro large-cap equity ETFs because it makes physically-replicated ETFs, such as iShares and HSBC, more expensive to run. But stamp duty doesn't affect the cost of synthetic ETFs."
The difference narrows with bond funds because they are cheap to run and offer low yields, so there is less scope for funds to charge high fees.
In addition, there are other reasons why investors have turned to ETFs. In times of high risk and stockmarket volatility, they offer the ability to buy or sell intraday, compared with traditional mutual funds valued only once a day.
The fact that ETF holdings are disclosed daily is also advantageous in uncertain times, compared with the twice-a-year disclosure of mutual fund holdings.
There are trading costs associated with buying an ETF, such as commission and the bid/ask spread, that are not reflected in advertised fees, but these one-off fees are relatively small.
There are comparitively few passive funds in the closed-end investment trust market. Edinburgh Investment Trust offers UK and US trackers with TERs of 0.34% for the UK version and 0.40% for the US version.
Here there are also opportunities to take advantage of discounts to a trust's net asset value, even though these are passive vehicles.
"And they do occur," says Robert Lockie, investment manager at Bloomsbury Financial Planning. "For some reason even the managers don't understand, as there is no active management for investors to vote against by selling. Investors can get the yield on 100% of the portfolio but they don't have to pay 100% to buy it."
Edinburgh's US trust is currently on a discount of 4.8%, and the UK version is on a discount of 3.7%.
"If a market is believed to be broadly operationally efficient, index tracking makes sense," says Scott Mowbray, a spokesman at Virgin Money.
"However you construct your portfolio it is essential to keep your costs down. A small decrease in fees could add hundreds, maybe even thousands, of pounds to your return depending on the size of your nest egg."
A big myth about investment fund charges is that the TER includes everything. Investors usually focus on the annual management charge when comparing investment fund charges, while the more sophisticated investor will look at the TER. However, neither of these measures tells the whole story.
One of the biggest costs associated with a fund is its trading costs, which reflect how often the manager buys and sells the underlying stocks or other assets, and this is not included in the TER.
A fund's transaction costs include fees associated with buying, selling, and rebalancing the underlying securities, such as stockbroker commission and stamp duty.
A fund with a high TER and high stock turnover could easily suffer a 5% annual total performance drag, which is more than an investor would generally be rewarded for holding equities instead of cash over long periods.
Turnover data can be difficult to obtain, but one source is Morningstar. We looked at eight of the most popular funds, and their published AMCs and TERs, together with turnover and the estimated drag this had on performance.
We estimated that 100% turnover of the underlying assets creates a performance drag of around 1% a year for equity funds.
That means if a fund has annual turnover of 200%, that translates to a drag of around 2%, which will be reflected in performance. Hidden drag from turnover adds as much as 0.9% to the cost of the popular funds we examined.
Over time, these charges mount up. Mowbray has calculated the reduced equivalent yield across a range of charges from 1 to 2%, assuming growth of 6% a year.
High turnover leads to poor performance
Many experts think the level of turnover in a fund relates to the time horizon a manager is focused upon. If the turnover is high, they are trying to make short-term predictions, which is a difficult strategy to pull off.
If turnover is lower, they are probably looking at the underlying business case for each stock over a matter of years, and this strategy is much easier to achieve successfully.
As the funds we looked at are some of the most popular, it is reasonable to assume their managers are doing well. If you look at trading across a wider universe of funds, it is clear that a high turnover is often associated with poor performance.
In fact, the only two equity funds over £1 billion that lost money for investors in the year to the end of October have very high turnover activity: JPM Europe Strategic Value turned over 231% of its portfolio last year; and Jupiter Financial Opportunities turned over 456%.
Trading costs also vary between different regions and sectors, as some assets are more liquid than others. Trading in a US large-cap fund is always going to be less expensive than trading Japanese smaller companies. The cost of trading different assets also varies. High turnover in high-quality government bonds will not make such a huge dent.
This article was originally published in Money Observer - Moneywise's sister publication - in December 2010
A hugely unpopular tax paid on property and share purchases. Stamp duty on property is levied at 1% for purchases over £125,000 (£250,000 for first-time buyers) which then moves up at a tiered rate. For property between £125k and £250k you pay 1%, then 3% from £250k up to £500k and then 4% from £500k to £1m and then 5% for properties over £1m. But unlike income tax, which is “tiered” and different rates kick in at different levels, stamp duty is a “slab” tax where you pay the rate on the whole purchase price of the property. On shares, stamp duty is charged at a flat rate of 0.5% on all share purchases. Figures correct as of May 2011.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.