ETF Investors Should Beware Hidden Costs

Despite total fees falling, investors should still beware less visible costs that can add to an ETF’s ongoing charge and eat into investor returns

Jose Garcia-Zarate 15 May, 2018 | 8:44AM

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The fee war in passive investing shows no sign of abating. Since the start of the year, many passive fund providers have either cut fees on their existing range or com to market with new offerings with ultra-competitive ongoing charges.

In March, Lyxor launched two US and UK equity ETFs tracking Morningstar indices with an ongoing charge of 0.04%.

In April, Xtrackers cut the ongoing charge for its EUR cash ETF to 0.10% from 0.15%, and for its range of US Treasuries ETFs by three-to-eight basis points. It now offers unhedged conventional and inflation-linked US bond exposure for 0.12% and EUR-hedged conventional bond exposure for 0.17%.   

Also in April, Fidelity launched six Irish-domiciled index funds providing exposure to US, Europe, Japan, Asia-Pacific ex-Japan, global and emerging market equity indices, with ongoing charges ranging from 0.06% for S&P 500 exposure to 0.20% for MSCI emerging markets. The asset manager also cut the ongoing charge for US, world, and equity UK-domiciled index funds to bring them in line with the newly launched cross-border range.

Fee cuts make good headlines and we are not ones to grumble about fund providers lowering the cost of investing. However, this is a good opportunity to remind investors that ongoing charges are not the only costs of owning a passive fund.

Buying and Selling Add Costs

Indeed, there are several, less visible, costs that can add up to a fund’s ongoing charge and thus eat into an investor’s returns. Many of these costs relate to the process of buying into and selling out of the funds.

For traditional mutual index funds, investors coming in and out will typically be asked to cover the transaction costs and taxes – for example, stamp duty in the UK – incurred by the fund so as not to penalise existing fundholders. These entry/exit costs can be expressed in the form of a spread or another price mechanism.

In the case of ETFs, which trade like common stock on the exchange, the trading costs for investors will come in the shape of bid-ask spreads and brokerage commissions.

In addition, investors who buy and sell passive funds on platforms also have to consider platform charges; typically an annual administration fee charged as a percentage of the amount invested on the platform and/or on a pre-trade basis.

All of the above could be described as “external” transaction costs. However, transaction costs are also incurred as part of the normal “internal” management of a passive fund. Indeed, indices are not static. Constituents come and go at each rebalancing, and they may also experience changes between rebalancings to reflect corporate actions or investment rating decisions.

Synthetic ETFs Have an Edge

Physically replicated index funds and ETFs have to reflect these changes, and the costs associated with the transaction of securities by the fund’s portfolio managers will directly affect the returns for existing fundholders. By contrast, synthetic ETFs, which deliver the performance of the index via a swap contract with a counterparty, are not directly affected by these costs. However, the level of index turnover will be factored in as part of the negotiation of swap fees, which are not included in the ongoing charge.

The transaction costs inherent to the management of a passive fund are out of investors’ control. However, this doesn’t mean that they should be ignored during your selection process. The good news is that passive fund management is highly automated and geared to a tight control of transaction costs and the exploitation of performance enhancement opportunities such as tax optimisation and lending securities.

It is clear that just looking at ongoing charges, while a good starting point, is not the best way of assessing a fund’s actual cost, and certainly not the only consideration when selecting a fund. A truer approximation of a fund’s total cost of ownership is to look at its annualised tracking difference – that is the difference in annual returns between the fund and its underlying benchmark – in addition to all the external and investor-specific costs incurred in the actual process of buying or selling the fund.

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

Jose Garcia-Zarate

Jose Garcia-Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe