ETFs can help protect returns from the dent made by active fund fees

Fund fees have fallen overall, but passive investments still offer the best defence against erosion of returns, writes Jose Garcia-Zarate.

The importance of fund fees can never be over-emphasised. They erode returns over the long term and we have little option but to pay them, irrespective of performance.

The growing market for passive investments over the past decade is testament to the way investors are increasingly looking for low-cost investment propositions. Meanwhile, regulatory changes such as the UK’s Retail Distribution Review (RDR) have also gone in the direction of lowering the overall cost of investing. In particular, the removal of commission payments from fund fees has seen a plethora of new share classes launched, commonly referred to as clean share classes.

Impact of RDR

Morningstar recently published an analysis of the RDR’s impact on open-ended fund fees against the backdrop of the rise in passive investing. We looked at a sample of funds, both active and passive including ETFs, that encompass the market exposures most commonly sought by UK retail investors.

We found that, on average, fees on actively managed equity funds have dropped by 18% since the introduction of the RDR five years ago, both as a result of the introduction of cheaper clean share classes and because of increased competition from passive funds. However, the latter have kept their competitive edge and their fees have dropped by an average of nearly 30% over the same period.

We found some of the biggest savings for investors in the UK and US large-cap equity categories. These are two areas that are likely to represent a significant allocation in most investors’ portfolios – UK for the home bias and US because it’s the largest superpower globally (our analysis period has coincided with a strong bull market for US equities).

Despite fee compression across the board, the gap between active and passive fund fees remains wide. For example, just looking at clean share classes, retail investors in a UK large-cap active fund would at present pay an ongoing charge of 0.75% on average, compared with just 0.12% for a passive proposition (whether ETF or traditional index fund) tracking a standard UK large-cap equity benchmark.

To see the effect of fees on returns, let’s assume an initial investment of £10,000 for a period of 10 years. We assume that during this period the UK equity market, as measured by the FTSE 100 index, grows by 5% per year. For the sake of simplicity, we assume no additional investment over the period. We compute no entry charges or other purchase commission – for example brokerage fees and bid/offer spreads for ETFs – or annual account-maintenance commissions.

At the end of the 10-year period, the value of our investment placed in a passive fund charging an annual management fee of 0.12% would be close to £16,100 and we would have paid just over £190 in fees. In the active fund, we would have paid close to £990 in management fees, so for the manager to deliver the same net gains, he would have to deliver extra returns over those of the index of around 0.67% per year – that is an annual return of 5.67%.

 

Higher hurdle to jump

This shows that, due to the higher fees they charge, active managers face a higher hurdle to deliver real outperformance. Indeed, in our scenario, active managers promising returns above the FTSE 100 could claim to have delivered the goods by returning anything above 5.01% a year. But would they have really? Not when compared with the returns and costs of the passive alternative, unless they returned more than 5.67%.

While assets have naturally increased significantly in the clean share classes of equity funds since the implementation of the RDR, there remains a substantial amount still invested in the old bundled share classes. Investors in these share classes face an even higher erosion of returns. For example, the average management fee of a bundled share class in an active UK large-cap equity fund is 1.41%. Anyone invested in these old share classes should therefore have a strong incentive to switch to the cheaper clean share classes.

We cannot control what the markets do, but it is in our hands to control the cost of our investments in order to improve the chances of a positive outcome.

Jose Garcia-Zarate is associate director of passive fund research at Morningstar.

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