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How Much Does it Cost to Invest in UK Equity Smart Beta ETFs?

Strategic-beta, also called smart beta, ETFs offering exposure to the UK all-cap market are more expensive than their market cap weighted peers thanks to higher transaction costs

Morningstar ETF Analysts 6 May, 2016 | 10:00AM

As assets in European strategic-beta ETFs have continued to rise, fees have declined. The average TER levied by European-domiciled strategic-beta ETFs has dropped to 0.39% in 2015 from 0.43% five years ago.

This decline can be solely attributed to the introduction of less-expensive strategic-beta products into the market. Virtually no provider has cut fees on existing products. This stands in stark contrast to the all-out fee war we have witnessed amongst providers of index funds and ETFs tied to standard market-cap-weighted benchmarks.

Nevertheless, there is still a wide disparity in the fees charged by strategic-beta ETFs, even across those offering exposure to similar strategies. All that said, it appears that fees don’t weigh as heavily in investors’ selection process for strategic-beta ETFs as they do for funds tied to more-traditional benchmarks. Instead, investors are more concerned with performance and the nuts and bolts of a specific strategy.

This is illustrated by the fact that the asset-weighted average TER has consistently been above the simple average TER over the past five years. Even though less expensive strategies are coming to the market, assets have generally stayed put in older and more expensive products.

Higher Transaction Costs Boost Fees

With an average fee of 0.42%, strategic-beta ETFs offering exposure to the UK all-cap market sit at the high end of the range of ETFs in our study, neck-and-neck with strategic-beta ETFs linked to the S&P 500.

Differences in fees between strategic-beta ETFs and market-cap-weighted ETFs in this category are not as significant as in the case of the S&P 500 ETFs. But that’s because we compared our sample of strategic-beta UK equity ETFs to FTSE All-Share ETFs. Had we compared our sample to ETFs that track the more narrowly focused FTSE 100 Index, the differences in fees would have been more pronounced, as many FTSE 100 ETFs now charge fees of less than 0.1%.

When looking at tracking difference – fund return minus index return – we found that strategic-beta ETFs linked to UK all-cap equities are also more expensive to hold, on average, vis-à-vis their market-cap-weighted counterparts. While higher TERs are the main culprit, higher transaction costs can also explain the gap. Every time a UK equity fund rebalances, it has to pay 0.5% stamp duty on the shares it buys. Because strategic-beta funds have higher turnover rates than market-cap funds, they typically incur higher transaction costs.

Table showing the cost of UK equity strategic beta ETFs vs market cap weighted ETFs

Finally, the table above shows that strategic-beta ETFs on UK equities are not necessarily more expensive to trade than plain-vanilla FTSE All-Share ETFs, with average spreads on the former coming in at 0.40% versus 0.45% for the latter. While many investors will likely be able to trade both types of ETFs at more favourable spreads, they shouldn’t expect to be quoted spreads as narrow as those they would get on FTSE 100 ETFs.

FTSE 100 ETFs benefit from highly liquid futures markets that market makers can use to hedge their exposure. In contrast, for UK all-cap ETFs, which also have exposure to mid- and small caps, there are no direct hedging tools available.

This article is taken from a report entitled Accessing the True Cost of Strategic-Beta ETFs written by Morningstar analysts Ben Johnson, Hortense Bioy and Dimitar Boyadzhiev

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Morningstar ETF Analysts  Alan Rambaldini is an ETF analyst with Morningstar.