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Exchange traded funds can keep a tight lid on costs, as they are passive instruments that do not rely on an army of expensive analysts doing complex research. On average, ETFs have management charges of 0.4 per cent a year, compared with 0.91 per cent for the average indexed equity fund and 1.8 per cent for active equity funds, according to research by Morningstar.
However, ETF annual management charges vary widely. They range from around 0.14 per cent a year for plain vanilla products tracking major markets such as the FTSE All-Share to 1.9 per cent for sophisticated products such as leveraged funds. Between these extremes, charges largely depend on the asset class and market the ETF tracks. The cheapest ETFs are the huge funds that follow major indices and therefore enjoy real economies of scale and liquidity.
‘The larger the fund, the better for every type of investor,’ says Eleanor Hope-Bell, head of intermediary business for Europe, the Middle East and Africa at State Street Global Advisors, which runs the SPDR family of ETFs. ‘The retail investor buying a traditional passive fund tends to get whacked with high fees because the amount invested is relatively low.
‘However, every investor in an ETF, from the person who buys a handful of shares to the very largest pension fund, pays the same amount per share, whereas private investors trying to purchase traditional passive funds will be offered much less attractive terms than large institutional buyers and may even be refused access altogether, as some have high minimum investment levels.’
Investors need to focus on the total expense ratio (TER), which includes the annual management charge and additional costs such as the fees paid to the trustee, custodian and auditors, but this alone will not tell the whole story, because it doesn’t include buying and selling costs. In the case of ETFs, these costs will include the cost of brokerage commission and the bid/offer spread, while traditional passive funds often charge a hefty upfront fee.
‘The conventional wisdom has been that if you are a small ETF investor doing lots of trades, trading costs will hurt relative to a similarly priced (traditional) fund structure,’ says Joel Dickson, senior investment strategist at Vanguard, which offers both ETFs (in the US) and passive mutual funds. ‘But brokerage commission is coming down and ETFs have become more liquid, so costs are less of an issue.’ Broadly speaking, as long as an ETF investor holds onto shares for a year or more, the cheaper annual costs will defray the upfront brokerage commission.
However, some traditional tracker fund costs can be just as low as ETFs, and what has most impact over time is the ongoing cost of the vehicle.
There can be a big difference in performance over time between all types of passive funds and that, over anything but the shortest timescale, it is the annual management charge that makes the big difference, irrespective of the fund’s label.
For example, the FTSE All-Share Total Return index has risen by 59.2 per cent over 10 years, with dividends reinvested. The F&C FTSE All-Share Tracker 1 fund has gained 59.1 per cent while the Nationwide version made just 45.3 per cent, reflecting charges of 0.3 per cent and 1 per cent respectively.
ETFs can be astonishingly good value, particularly emerging market equity funds, where TERs on London-listed ETFs start from 0.65 per cent. Direct access to emerging markets is otherwise complex and involves heavy brokerage and transaction fees, as well as custody costs and foreign exchange risk.
There has been a lot of debate and publicity around the level of risk involved in buying ETFs that use derivatives such as swaps to track the underlying assets. Broadly speaking, iShares and HSBC use physical assets while db x-trackers, Lyxor, ETF Securities and newcomer Ossiam primarily use stock synthetics. Credit Suisse uses a mix.
‘A swap-based strategy will always track the index better than one using physical assets, because that is the nature of the contract with the counterparty,’ says Jean-Francois Schmitt, head of quantitative equity at HSBC Global Asset Management. ‘Swap-based products are typically slightly cheaper, as there are no trading costs associated with rebalancing the portfolio and no stamp duty.
‘However, the collateral used may have no link with the index tracked. It would be possible, for example, in a rare case of default, to buy a swap-based ETF tracking a European index and end up with some small Japanese equities as collateral. Investors have to work out the trade-off for each specific market.’
Companies that use multiple swap providers will offer better protection, as this ensures diversification of counterparty risk, but it is worth remembering that, under Europe’s Ucits III regulations, ETFs can only use swaps to replicate the index for 10 per cent of the value of the fund.
A handful of swap-based ETF providers now disclose daily snapshots of substitute/collateral baskets on their websites, and other providers have indicated that they will follow suit.
The Financial Services Authority and the Bank of England may tighten rules on the marketing of swap-based ETFs. Events such as the demise of Lehman Brothers in September 2008, an event many did not think was possible, make it difficult to guarantee a bank default will never happen again, even if the risk is tiny.
An ETF that holds physical assets is clearly the more transparent alternative. It also allows investors to benefit from stock lending, where stocks are lent to a third party such as a hedge fund for a fee. This income is split between the provider and the shareholders. iShares, for example, splits securities lending income 60:40 in favour of the investor.
The return achieved by stock lending varies, from just a couple of hundredths of a per cent for the FTSE 100 to 0.5 to 0.75 per cent for the Dow Jones Euro Stoxx index, owing to financial institutions looking for ways to reduce the withholding taxes paid on dividends.
There are risks attached to securities lending, however. Counterparty risk again rears its head, as the borrower may go bust, and there is collateral risk, because the collateral exchanged for the security may not be of the same value. But securities lending isn’t unique to ETFs. Mutual funds do it too.
Passive funds that track a specific index will be very similar, but not identical, and choosing the most appropriate index and provider is more complicated than it looks. Many ETFs that sound similar track quite different indices, or the same index calculated differently.
Take the treatment of dividends. Manooj Mistry, head of db x-trackers UK, says: ‘Equity ETFs can often be split into two types: total return ETFs, where the dividends are reinvested, and price return ETFs, which will track the price of a basket of securities with no dividend reinvestment – which makes it easier to compare the ETF with movement in the indices.’
Some ETFs are paid net of withholding tax. ETFs that track the MSCI Developed Europe index, for example, can be based on total return net of tax, total return gross of tax or price only.
‘The differences between apparently identical indices can be significant,’ says Sofia Antropova, investment strategist at iShares. ‘In the fixed-income space, for example, index providers such as Markit iBoxx, Barclays Capital and EuroMTS have different criteria for inclusion based on credit ratings. As a result, some European government bond indices may include Greek government bonds, which may undermine their performance compared with those benchmarks that have already excluded Greek bonds using stricter credit-rating criteria.’
Physical funds have different tracking methodologies. There is little point choosing a fund with lower charges than its rivals if its returns consistently lag the benchmark.
Full replication means a fund will hold every constituent in the index with miniscule tracking error, but it will incur high transaction costs in rebalancing. Partial replication, sometimes referred to as optimisation, means that a fund samples a portion of its benchmark’s securities to avoid the cost of holding them all, but this inevitably results in tracking error. As a rule of thumb, annual tracking error of more than 2 per cent is too high.
Partial replication can reduce custody costs, as very small holdings burden the fund with costs.
Essentially, however, ETFs offer retail investors a similar risk-return profile to the index tracked and their diversification will be equally as strong, allowing them to create a truly diversified portfolio.
Income strategies and other themes
ETFs can be used to play a raft of investment themes, including industrial sectors, ethical and environmental funds, Shariah funds, and value and growth investment style biases.
High-dividend funds have become popular, as it is hard to generate income elsewhere in the market. iShares FTSE UK Dividend Plus aims to track the performance of the FTSE UK Dividend+ index – the 50 highest-yielding shares in the FTSE 350 index – and its 12-month yield is 5.5 per cent.
Some research suggests dividend-weighted indices can generate higher returns with lower volatility than standard indices. However, dividend-style indices can suffer high turnover and trading costs. For example, before the 2008 crisis, all UK banks were in the index, but they dropped out when they failed to pay dividends for 12 to18 months.
Lyxor Euro Stoxx 50 Index Dividend Futures offers something different. It enables investors to take a position on the index constituents’ annual cumulative realised dividends. In this way the fund gives long-term exposure to dividends as an asset class and may provide a hedge against inflation, as yields and inflation are highly correlated.
Infrastructure ETFs such as iShares FTSE/Macquarie Global Infrastructure 100 have also been popular this year, as they too can provide a hedge against high inflation.
More than 60 currency ETFs are listed on the London Stock Exchange, a segment dominated by ETF Securities, which has listed a massive range of funds that offer investors an opportunity to buy or go short on a wide choice of currency pairs.
Currency trading grew in popularity with private investors in the aftermath of the financial crisis, when attractive returns were difficult to find and investors were looking for assets with little correlation to equity markets. As a zero-sum game, currency trading always produces some winners.
The best-known return-generating strategies are momentum trading, valuation trading and the carry trade, in which low-yielding currencies are sold in favour of
higher-yielding alternatives with the aim of earning a spread based on the interest rate differential.
Db x-trackers uses all three in its Currency Returns ETF, which comes in sterling- and dollar-hedged versions. For an annual fee of 0.35 per cent, these offer long and short positions in G10 currencies. Exposure is equally weighted to three underlying currency strategies using a rules-based process and regular rebalancing of positions.
Currency ETFs can also be used to hedge the currency risk in other investment positions. For example, db x-trackers launched a euro-hedged gold product in Germany last year that has been well taken up. Most commodities are priced in dollars so, left unhedged, positive gains can be drowned by currency movements.
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