February 2012
ETFs are not the low cost option many say they are.
Some big names have entered the fray about fund management fees and the temperature of the debate has risen. But there is still more heat than light.
It might aid understanding if fees are broken down into two elements; performance and costs. Moreover, costs themselves can be disaggregated into two elements, discretionary and non-discretionary. Much of the moaning about fees is a consequence of capital markets that have oscillated between lacklustre, abysmal, downright scary and, occasionally, euphoric. Poor performance giving flat or negative returns have caused investors to ask questions about costs that never bothered them when rising equity markets delivered gains almost irrespective of costs. Few took the trouble to ask if the fund had matched the relevant index or whether the returns matched the risks incurred.
Discussion on fees is further clouded by the fact that it actually covers two factors: costs and fees. Costs are unavoidable and are simply one of the inputs into any business. In fund management one of the biggest costs is stamp duty at 0.5% which goes straight to the exchequer. Other unavoidable costs are audit fees, FSA levies, custodian and trustee fees and administration costs. There is also a big difference in the cost structure of the vehicles, OEICs and ETFs, used to hold the investments. Despite claims to the contrary ETFs can be a more expensive way of holding securities than via an OEIC even though investors don’t have to pay stamp duty on purchase.
The debate about cost really focuses on the discretionary element which is essentially the amount of trading a fund does to generate alpha. It can be difficult to calculate that cost because of the spread in the quoted price of the underlying securities. This is the difference between the bid and the offer price and is where the market maker makes his turn. The more a fund trades the more it pays away to counterparties and in stamp duty. Moreover, the cost is larger when trading in the shares of small companies where lower liquidity often means higher spreads. There is though a simple short-cut to get an idea of how much cost is incurred by a fund. A quick look at its portfolio turnover rate tells you a lot. A fund with a low figure, like the 3% of The Munro Fund, will have lower trading costs than an active one, especially one focussed on small cap stocks.
In the end the best measure of the effectiveness and efficiency of a fund can be determined by its performance. Bearing in mind that many people believe share price movements for any period less than a year is simply noise it is best to select as long a period as possible to assess net returns. Fundamental Tracker Investment Management Ltd has assembled its own proprietary data base of the returns generated by ETFs and OEICS investing solely in UK equities that can be described as beta or smart beta-funds. These funds are all passive and most strive to deliver the returns of the index to which they are benchmarked.
One thing that is clear from the sanitised data presented below is that where an ETF and an OEIC both follow the same index, other than the FTSE 250, the ETF usually delivers a worse return than the OEIC. It seems that is because total costs on many ETFs are actually higher than the comparable OEIC despite stated quoted total expense ratios (TERs) of about 0.5%. Additional trading must be the prime suspect here.
| NAME | Returns Since end 2007 |
| ETF FTSE 250 | 4.67% |
| OEIC-FTSE 350- | 4.39% |
| UT-UK EQUITY TRACKER- | 2.74% |
| OEIC ALL SHARE TRACK- | 2.28% |
| ETF FTSE 250 ETF | 1.86% |
| OEIC EQTY- | 1.71% |
| OEIC ALL-SHARE INDEX- | 1.64% |
| ETF FTSE 250 | 1.62% |
| OEIC INDX | 1.42% |
| OEIC UK IND TR | 1.41% |
| OEIC UK INDX- | 1.19% |
| OEIC FTSE 250 INDEX- | 0.56% |
| OEIC UK TRACKER | -1.89% |
| OEIC UK FT ALL-SHR- | -2.06% |
| OEIC FT 100 IND- | -4.15% |
| ETF FTSE ALL-SHARE | -5.57% |
| ETF FTSE 100 | -5.82% |
| OEIC FUND- | -6.92% |
| IT UK TRACKER | -7.38% |
| OEIC UK TRACKER- | -8.96% |
| ETF-TRACKERS FTSE ALL SHARE | -9.05% |
| OEIC UK INDEX TRACKING | -9.63% |
| OEIC INDEX TRACKER | -10.25% |
| OEIC FTSE ALL-SHARE | -10.29% |
| ETF FTSE 100 | -10.72% |
| UT 100 FUND | -11.36% |
| OEIC FTSE 100 INDEX-INC | -11.42% |
| ETF FTSE 100 | -11.76% |
| OEIC TRACKER FUND- | -12.07% |
| OEIC UK - | -17.27% |
| ETF FTSE UK | -17.38% |
| ETF FTSE UK | -33.95% |
| Source: Bloomberg |
ETF providers make much of the fact that investors don’t have to pay stamp duty when they invest in an ETF. That 0.5% head start ought to help ETFs outperform OEICs. Yet the returns over the last four years indicate that this advantage has not delivered additional benefits to investors. The only reason for that must be that ETFs incur additional costs and that trading, including derivatives, must be the most likely culprit. These costs are charged to the fund and impact the net return received by the investor. Indeed, this is the case. Where ETFs publish turnover rates they are typically much higher than OEICs and can be over 100%.
Proponents of ETFs claim one advantage is the ability of investors to trade at any time during market hours rather than just once a day as with an OEIC. Yet this a spurious benefit if the aim is to invest over a period of decades. As a consequence the investor is paying a premium to get extra liquidity that is of no practical use to them. Some recent converts to passive investing using ETFs make a lot of noise about increasing transparency as a means to reducing costs. Unfortunately, the facts do not really support their argument because the TERs for ETFs, as with OEICs, do not include their trading costs. ETFs that trade more, either directly or indirectly through derivatives, will always provide lower returns than simple buy and hold OEICs.