Trackers versus ETFs: the passive price war
|August 27, 2013 15:15 (CET)|
In a world where charges are being scrutinised, exchange-traded funds (ETFs) should be the heroes taking the spotlight. The low cost aspect is one of the main tenets underpinning the ETF’s rise to fame over the last 10 years in Europe.
Take a closer look, however, and it is evident that ETFs are not necessarily the cheapest vehicle in the market across the board. The increasing competition in Europe, due to the proliferation of traditional index trackers and new entrants, is starting to expose the relatively high charges on some ETFs among certain providers in particular.
Yet, does this increasing competition translate as pressure and mean that Europe could see a US-style ‘price war’, where providers are compelled to cut charges to attract money? Or are investors content with paying a little more to potentially gain tighter tracking error, greater liquidity and ultimately a more efficient vehicle?
The competition has heated up as more asset managers look to profit from the expanding passive market by launching into the arena or bolstering their existing product range. Only recently L&G Investment Management said in its results that it aims to significantly expand its offering of passive products in the UK and overseas and stated index funds are also a key component of its own multi asset funds.
The building pressure on prices is further exacerbated by the introduction of the Retail Distribution Review in the UK, which has seen the emergence of clean share classes on active funds. These new share classes have stripped out the commission previously paid to advisers, bringing the costs down to levels that almost rival the charges on more expensive ETFs.
In the passive space alone, some of the headline charges on existing index trackers and new ETF entrants are highlighting the higher charges of some of the larger, older ETFs and more established players.
For example, Swip offers a FTSE All Share index tracker with a total expense ratio of 0.10 percent. By comparison, one of the lowest cost ETF versions on the same index is offered by db X-trackers, coming in at 0.40 percent.
Within the ETF realm, Vanguard launched an ETF on the FTSE 100 with a TER of 0.10 percent, significantly undercutting the iShares equivalent at 0.40 percent.
Obviously it is down to the individual as to whether cost or efficiency is prioritised, but then perhaps these two factors should not be taken as mutually exclusive. There is growing traction behind the idea that more expensive ETF providers can shave their charges to meet competition from new ETF providers and cheaper trackers, but preserve their superior tracking error and service quality among other benefits.
“When it comes down to a few basis points here or there, then investors might be willing to pay a little more for ETFs where there is liquidity or, for example, transparency on securities lending,” says Ben Seager-Scott, senior research analyst at Bestinvest. “But more than 10 bps, say, and there is much more of a differentiation.
“I definitely think there is room to cut charges. iShares are incumbent in Europe, and haven’t had much US competition in the past. But now the big US players are coming here.”
He highlights that players in Europe have backed the emergence of the ‘Smart Beta’ concept, launching products on alternatively weighted indices which, a lot of the time, necessitate higher headline charges.
“There are more local European players expanding into niche markets, such as Smart Beta,” says Seager-Scott. “The gap isn’t that large between their costs versus lower-cost active funds especially post RDR.”
Cost is not the only factor worth considering and other seemingly unrelated aspects of the investment can actually add to the total charge.
As Chris Aldous at Evercore Pan Asset highlights, ETFs tend to have much better tracking error than traditional index funds, although he adds that this benefit, along with the intraday liquidity offered by ETFs, are not necessarily for everyone and worth the premium.
“Costs can be extremely important,” says Aldous. “Where you don’t need high levels of liquidity, trackers are good for most model portfolios.”
Evercore recently launched a range of model portfolios based on trackers, mirroring the asset allocation of its existing PanDynamic portfolios of ETFs. The new Pan Model range is around 5-10 basis points less expensive than the older ETF-based PanDynamic version.
However, Aldous emphasises that there is more to the headline cost and that when other charges are bolted on, the total cost of ownership can mean some seemingly cheap products can turn out to be more expensive.
For example, trackers investing in UK markets add on stamp duty of 0.50 percent. Vanguard also adds on a ‘liquidity charge’ to protect existing investors in the fund. Yet this is another expense, which might not be immediately obvious, that needs to be taken into account. In some cases it can be as high as 0.75 percent – the charge attached to the firm’s Barclays Global Aggregate UK Non-Government Float Adjusted Bond index.
Equally, the headline TER on an ETF does not include the impact of securities lending, tax, trading costs and brokerage fees among other costs. iShares gave an example to show how the TER does not give an accurate indication of the total cost of ownership (TCO) and in this case, shows how costs can be lower.
Looking at its iShares Euro Stoxx 50 ETF domiciled in Dublin, which has an annual TER of 35 bps, iShares says the tracking difference of the fund over a certain period was positive 54 bps after TER, due to securities lending revenue and tax differentials.
However, the 12-month average on-exchange trading spread was 8.3 bps, meaning the TCO is the outperformance of 54bps minus 8.3bps, to come to a positive 45.7 bps excluding factors liked brokerage fees.
The charges displayed in the form of the TER are therefore not the final costs investors end up footing, but this is not an issue only affecting the passive realm. Conversely, index trackers and ETFs are arguably much more transparent than active funds.
Yet, many of the factors contributing to the TCO are unknown and not necessarily stable, whereas the fundamental TER or annual management charge is firmly in place. Consequently, the more competition that comes into the arena and exerts downward pressure on TERs and overall costs can only be welcomed. After all, ETF providers should strive to offer competitive fees to preserve one of the main building blocks that formed the basis for its rising popularity.
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