Exchange traded funds vs passive mutual funds

Published by Ceri Jones on 02 December 2010.
Last updated on 08 December 2010

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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.

Daily disclosure

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."

Additional costs

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


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