Why investors should not fixate on falling passive fund fees

Passive funds have relentlessly pared back their fees, but a tracker choice should be about more than low charges alone.

Academic finance is now dominated by the ‘efficient market’ hypothesis. Try as they might, the theory goes, active fund managers almost never outperform the market over the long term. Investors, therefore, have no hope of beating the markets, so they are better off sticking their cash in either index trackers or exchange traded funds (ETFs). Acceptance of this theory has played no small part in an explosion in the popularity of passive investing over the past decade.

That said, for Jack Bogle, the late founder of Vanguard and so-called father of index investing, the question of whether or not the market is too efficient to beat was never a primary concern. As Bogle saw it, the key benefit of the investment products he pioneered was that they charged investors the smallest fees possible. Without the cost of a manager choosing stocks, ETFs and index funds were, and are, simply cheaper to run.

Fees, he argued, are the real drag on investment returns that should concern investors. Bogle argued that investors will always struggle to know which direction market will move in from one day to the next. The one thing that is under their control, he maintained, is the fee they pay.

Compounding catch

This view is echoed by Liz Wright, senior ETF specialist at Vanguard. “You can’t control the market, but you can control what you pay to invest,” she says. “Every pound out of your pocket [in fees] is a pound lost in potential returns.”

One of the first lessons investors are supposed to learn is the power of compounding. Compounding is usually discussed in a positive context, with graphs and tables showing how investment returns themselves generate gains. As each year passes, the compounding effect multiplies. Unfortunately, compounding can also damage total returns, as the effect of fees also compounds over time.

To illustrate her point, Money Observer ran calculations using Candid Money’s calculators on a £10,000 lump sum invested for 30 years in two different funds, each of which generates annual returns of 5%. The first fund charges a fee of 1.5% a year, a typical fee for an expensive actively managed fund. The second charges just 0.1%, which is what one might expect to pay with one of the cheapest ETFs available. In the 0.1%-charging ETF, that £10,000 would turn into £42,001 over 30 years. However, in the fund charging 1.5%, the £10,000 would grow to just £28,068 over the same period – about a third less.

Recognition among investors of the powerful effect of costs on long-term performance has pushed many ETF and index tracker providers into a race to the bottom in terms of fees. According to the Investment Company Institute, the average asset-weighted expense ratio sank to just 0.21% at the end of 2017 – so for every £1,000 invested, an investor pays around £2. With the price war still being waged, that figure is likely to have fallen further since.

Investors should bear in mind, though, that as costs edge closer to zero, the potential savings from each cost reduction diminish. A 10% cut to that average expense ratio of 0.21%, for example, would shave about two basis points off what an investor would pay. That will have a minimal impact on their investment returns.

Oliver Smith, portfolio manager at IG, says: “In monetary terms, two basis points is £200 for every £1 million invested. All things being equal, if you had invested £100,000 for 20 years for a net return of 7%, your pot would be worth £386,968; at 6.98% it would fall short [of that figure] by £1,444.”

A graph showing how index choices can impact returns


Look beyond fees

The race to the bottom on fees highlights the importance of other metrics when choosing an ETF (assuming you have decided on the asset class).

Take an investor who wants to track emerging market stocks. The investor is weighing up investing in either the Invesco MSCI Emerging Markets ETF or the Vanguard FTSE Emerging Markets UCITS ETF.

If ETF and passive investment selection were purely about keeping costs under control, the obvious choice would be the cheaper option. In this scenario, that would be the Vanguard ETF, which has a fee of 0.25%, while Invesco’s is 0.29%. However, the impact of this choice is minimal (see box on page 33): it amounts to a gain of just a few hundred pounds over 20 years – a blip in the context of overall portfolio performance.

With neither fund offering a clear benefit in terms of fees, the investor must take a look ‘under the bonnet’ for differences between the funds that may affect their investment decision.

In the scenario outlined here, both ETFs track emerging market equities, but they follow different indices – the Vanguard ETF tracks the FTSE Emerging Market (China A shares included) index while the Invesco ETF tracks the MSCI Emerging Market index – and these indices differ in terms of the countries they deem to be emerging markets. The MSCI designates South Korea an emerging market; the FTSE doesn’t. The Invesco ETF has 13% of its holdings in South Korea; the Vanguard ETF has nothing invested in the country. There are other differences. The Vanguard ETF has an exposure to China of 33.5%, slightly higher than Invesco’s. On top of that, while roughly 25% of Invesco’s ETF is invested in financials, against 30% of the Vanguard ETF.

The different share allocations of these ETFs are reflected in the various metrics used to measure their holdings. The Vanguard ETF (as of 8 March) has a price-to-earnings (p/e) ratio of 12.9 times, while the Invesco ETF has a p/e ratio of 11.1 times, for example. For investors, particularly those looking for value, that difference may be important.

There is a slight difference in the performance of the two ETFs: the Vanguard ETF has delivered a total return of 54.2% over the past five years, while the Invesco ETF has returned 48.5% (see chart opposite). It’s difficult to determine what exactly was behind the difference. With both ETFs’ fees so low, index variables have most likely played a role.

Costs in context

In this case the cheaper ETF (Vanguard) actually performed better. However, the key point is that different indices tracking the same asset class can show a divergence in returns. By following the lowest investment costs among already ultra-cheap ETFs, an investor might select the less rewarding ETF. Of course, working out which index will perform better is by no means easy.

Investors can opt to track more niche indices if they believe a particular sector (or theme) will outperform. However, they will often pay slightly higher fees for the privilege. Those who believe prospects for emerging markets are rooted in the increasing consumer power of the growing middle classes in Asia and Latin America might choose emerging market exposure through the iShares MSCI EM Consumer Growth UCITS ETF, for example. This ETF tracks the MSCI Emerging Market Consumer Growth index, so its performance may diverge from the broader MSCI emerging market index.

Its fee, however, is 0.6% – higher than the Invesco and Vanguard ETFs already mentioned. Assuming the iShares ETF delivers a 6% return, it would turn £10,000 into £28,629 over 30 years. That is not hugely out of line with the £30,000 figure for Vanguard and Invesco (see box below). However, it does mean that an investor will have paid £3,442 in fees, twice the Invesco ETF’s fees of £1,710.

Of course, anyone buying the iShares ETF should be doing so in the belief that consumerfocused companies in emerging markets will enjoy better growth than the market as a whole and that its returns will be higher, making the ETF’s higher fees irrelevant. As Smith says: “Thematic investments are worth paying for if the long-term diversification and return profiles are attractive.”

There are other differentiators investors may want to ponder. Smith points out that the liquidity and bid/ask spread of an ETF are just as important as its price, particularly in a world of near-uniformly low-cost ETFs. He says: “I would always look to buy an ETF with greater value of assets under management, as that should ensure, first, that it survives and, secondly, that the bid/ask spread will be competitive. In an industry where fees are falling, frictional costs from bid/ask spreads can be far more important than differences in management fees.”

Other priorities

The relentless downward pressure ETF providers have exerted on their fees has made charges a minor consideration for investors.

While Bogle’s dictum that costs are the most important consideration for fund investors holds true for active funds, the ability of ETF providers to drive down costs to such rock-bottom levels means investors can pay more attention to other costs and concerns.

For instance, Wright says: “While in some areas of the market, the difference between fund costs may only be a couple of basis points, an investor is also paying transaction costs and platform fees.”

She points out that platform fees in particular often vary by as much as 30 basis points. Getting those fees right can lead to “a substantial saving over time”. Costs do matter, so every investor should consider an ETF’s cost before investing; but that said, low ETF fees now free investors to turn their attention to other factors acting as drags on their returns.

Fees becoming a minor concern

Passive fund fees are now so low that the long-term impact on returns of differences in the fees funds charge is minimal. The Invesco MSCI Emerging Markets ETF charges 0.29%, while the Vanguard FTSE Emerging Markets UCITS ETF charges 0.25%. That is a 16% difference. Over 20 years, assuming a 6% return, the Vanguard ETF would turn £10,000 into £30,592. The Invesco ETF would turn that £10,000 into £30,362. The difference between the two is just £230, a tiny amount over 20 years.

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