Low Cost Investing: More Than Just ETFs

Morningstar are unfaltering supporters of low-cost investing, but there are significant differences between passive and low-cost investing

Dan Kemp 29 May, 2018 | 11:56AM

Warren Buffett continues to solidify his reputation as one of the most likeable, warming, thoughtful investors to have graced the planet. Yet in his public dialogue over the past 10 years, he has inadvertently contributed to the changing face of investing.

More specifically, his advocacy for everyday investors to use low-cost passive investment vehicles, along with the likes of Jack Bogle, the founder of Vanguard, has contributed to a growing pool of support towards the ascendancy of low-cost investing. In fact, the rise of passive funds has resulted in a 537% increase in total assets since 2007 versus only 137% for active funds.

Worldwide fund flow data (including ETFs) shows the remarkable trend in favour of passive investing

The Way We Think About Fund Fees

As a firm that has been at the cutting-edge of manager research for more than 30 years, Morningstar Inc. have become known as unfaltering supporters of low-cost investing. In fact, Morningstar research has consistently shown that lower-cost funds have a significantly higher likelihood of success than higher-cost funds. For this reason, “strive to minimise costs” is one of the seven investment principles that guide our thinking. 

The central idea behind our investment selection process is that any fund, regardless of style, is worth considering if it will help a client to meet their goals. In this sense, we are agnostic to the active versus passive debate, adopting the same appraisal system for all investment options. However, inevitably, the cost of holding an asset will have a significant impact on our determination.

Worldwide active/passive exposure (including ETFs) shows the scope for further growth

Assessing Passive Funds

Within the passive fund industry, we continue to see a significant consolidation in providers. While this is generally perceived to be a good thing, the major providers are generally reputable and tend to have tight risk controls, it is worth noting that passive funds are not always a silver bullet. There are several unique considerations an investor should weigh, so below we detail five of the more important points:

Passive investing has dangers in illiquid asset classes. If you want to obtain exposure to an illiquid asset class, passive investing can increase the risk of getting caught in a liquidity crisis. This is a large reason behind the reluctance of Blackrock, Vanguard or State Street to open funds in illiquid assets such as high yield fixed income.

Fund size matters. The consolidation in the passive fund industry has only occurred at a parent level. The number of fund options continue to expand at a rapid rate, which should be viewed with caution for the newest and smallest offering. Specifically, when a passive provider launches a new fund, they can have problems replicating the index without incurring excessive transaction costs. This can increase tracking error and lead to underperformance.

Beware of synthetic offers and be aware of securities lending. In the early development of passive funds, there were some major concerns as some providers were offering synthetic exposures, obtaining exposure via derivatives, rather than pure holdings. Thankfully, most of the better-known parent companies which dominate the industry do not entertain such risks.

However, a more popular trend that is still practiced today in ETF’s is the use of securities lending, which derives additional revenue by borrowing against the holdings and is intended to bridge the gap between the index and any transactional fees, as well as an additional revenue source for the manager. While this is often considered very low-risk, it may not be something an investor wants to expose themselves to.

Check what index they are tracking. Often, investors will simply compare two North American tracker funds and assume they do the same thing. This is a misconception, as a fund that tracks the S&P 500 will invariably produce different performance to one that tracks a North America index, which includes Canada. The same problem occurs in Europe and across many asset classes.

Fees still matter. The fee range is still wide, even within the passive universe, so investing blindly into a passive ETF or index fund can result in inferior results. Costs vary depending on the asset class and provider, which will have a significant impact on the net result for the fund. The process by which they replicate an index will also have an influence on performance, as most providers attempt to add value by actively trading exposures in a risk-controlled manner.

What Does the Future Hold for Passive Investing?

To us, the real question is whether passive funds help align investment outcomes to client objectives, which is really the point of the discussion. In this regard, we welcome the recent developments and suspect that the rise of passive investing will not mature for a long time yet. While active funds still dominate the industry, the movement towards lower costs is forcing asset managers to adapt.

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

Dan Kemp

Dan Kemp  is Chief Investment Officer, Morningstar Investment Management EMEA