Vanguard's with its ultra-low cost tracker funds has reignited the age old debate around funds and the fees they charge, with rival tracker fund providers starting to feel the heat. But the 'Vanguard effect' is also bringing actively managed funds to trial as a changing funds' landscape demands that active managers start earning their keep.
There is no disputing that costs are among the most important factors, if not the most important factor, when choosing a fund.
"Costs chip away at fund performance year after year and their impact compounds over time. There are few factors as predictive of future success as fees - the lower a fund's fee relative to similar funds - the greater its chance of outperforming," says Chris Traulsen, director of fund research at Morningstar.
The total expense ratio (TER) is regarded as the best measure of a fund's bang for the buck, and in its simplest form, equates to the total fund costs, divided by the total fund assets. This figure basically constitutes the annual management charge (AMC) plus various other charges levied during the course of a year such as audit, custodian and legal fees.
"These are what might be termed 'hidden fees' but are nevertheless a drag on performance and it is therefore perhaps better to look at TERs than AMCs when considering annual charges," says Andy Gadd, head of research at independent financial adviser (IFA) Lighthouse Group.
In many of Vanguard's offerings, the TER is the same as the AMC. This is achieved by paying all of the fund's expenses out of the management fee rather than as an additional deduction from the fund's assets.
Vanguard's UK trackers boast TERs ranging from between 0.15 per cent for UK equities and 0.55 per cent for emerging market equities - a far cry from traditional tracker funds in the UK, which have typically had TERs hovering around the 100 basis points mark.
"Vanguard's entry does add an interesting dynamic given that they have entered the market with the explicit goal of being a low cost provider," says Mr Traulsen. "HSBC reacted pretty quickly to Vanguard's low cost offering, . Funds that used to cost more than 100 basis points a year, are now pricing in at around 27 basis points a year. This is an enormous cut and it suggests that HSBC had built in some very fat margins for themselves on what are in truth very low-cost offerings.
"No research goes into an index fund - it is simply a matter of managing the trading strategies to make sure you track the index well. To pay 100 basis points and more for an index fund is just silly and I don't understand why anybody would do it."
A notable difference between Vanguard's and HSBC's offering is that while none of HSBC's funds carry initial charges, some of the Vanguard funds carry small 'purchase fees'.
According to Vanguard these fees are to cover the transaction costs involved in buying the underlying securities held within the fund. This could be local taxes, or bid-offer spreads on stocks or bonds in less liquid markets. In some mature equity markets transaction costs are low and no purchase fee is charged and with spreads on UK investment-grade bonds currently above the historic norm, as these reduce Vanguard expects the fees to do likewise.
Look at the total charges
"Investors need to assess the total cost, not just front end charges. For example, Vanguard UK Equity Index carries an initial fee of 0.50 per cent to cover stamp duty, but its projected TER is 0.15 per cent, 0.12 per cent per year less than the HSBC offering. Hence, if you plan to buy and hold for the long term, then the Vanguard offering would be the better deal. If you think you'll sell in less than five years, the HSBC FTSE All Share would be the preferred choice," explains Mr Traulsen.
Four years prior to Vanguard's entry into the market, Fidelity cut the AMC on its UK index tracker fund - the Fidelity Moneybuilder UK Index - to just 0.1 per cent to retail savers, a tenth of the charge imposed by larger tracker groups.
The reduction, which took place in September 2005, lowered the TER to 0.27 per cent, and sparked a massive increase in sales for Fidelity. While some predicted the move will cause an upheaval in the sector, the figure now matches the projected TER on the HSBC offering.
Despite competition on the cost front mounting, a recent analysis by Fidelity shows that three-quarters of UK tracker providers are still imposing total costs of 0.5 per cent or more on funds which shadow the movement of indices such as the FTSE All-Share or the FTSE 100. The findings also reveal that a handful of UK tracker funds still have front-end charges, in some instances of up to 5.50 per cent.
Despite HSBC not being particularly known for its tracker offering, it has very quickly come to party, while providers like Legal & General - probably the best known tracker provider in the UK - are still sitting on the sidelines. "L&G's offerings are still very much on the expensive side and it would be interesting to see how and if they react," says Mr Traulsen
On ETFs and the RDR
While Vanguard's cost onslaught has certainly put the pressure on tracker providers, Mr Traulsen believes that exchange-traded funds (ETFs) - having been in the UK for close to a decade now - have done more to heighten investors' cost awareness.
Often dubbed the 'next generation of index funds', ETFs offer investors the ability to trade a single investment instrument based on an index.
Despite ETFs offering some of the most competitive TERs for funds, there is no doubt that these providers are also feeling the impact of heightened cost competitiveness, with db x-trackers recently reducing the TER or all-in fee of the db x-trackers DJ Euro STOXX 50 ETF from 0.15 per cent per annum to zero.
While institutional investors have long since been engaging with ETFs, private investors are only slowly waking up to the diversification and cost benefits of these vehicles.
"Part of the issue you have in the UK is that it is an intermediary-driven market, with around 85 per cent of fund inflows coming through IFAs, and while they want to do the right thing for investors, they also want to get their commission," says Mr Traulsen.
IFAs typically receive an upfront commission for getting an investor into a fund, as well as a trail fee built into the fund's TER. Due to their small profit margins, ETFs do not pay trail fees, and consequently have not been favoured by IFAs, other than by those charging clients for the advice received on an upfront fee basis.
But with the Financial Services Authority's proposed Retail Distribution Review (RDR) to be implemented by December 2012, this could very well change.
The RDR proposes a radical overhaul of the retail investment market which will seek to put an end to the practice of offering advisers upfront commissions to sell investment products.
"If the move to a greater proportion of fee-based financial advisers goes through, then there will certainly be a greater ability, or willingness, for these advisers to offer funds with lower annual charges. Most obviously this would benefit lower cost funds, such as index trackers and ETFs, but potentially on the actively managed side too, with 'trail-free' share classes being created on existing actively managed funds," says Ed Moisson, director of fiduciary operations at Thomson Reuters. Invesco already offers funds without trail commission - lowering the annual charges by 0.5 per cent. Also, investment trusts do not charge trail commission so this is one part of the UK investment industry that may benefit on the actively managed side.
Mr Moisson points to the entry of investment trust giant Alliance Trust to the open-ended funds market as an interesting example of how trail fees can push up costs. Originally an investment trust with a TER around 0.5 per cent and assets of £2.1bn, the company broadened to launch two open-ended funds in 2009. These funds bear an estimated TER of 1.38 per cent for private investors, which is below sector averages, together with a performance fee, based on 20 per cent of net gains, which is limited by a cap of 6.25 per cent per annum.
So, if one of the funds fails to perform as intended, it will charge around two and a half times more than the closed-ended fund from the same company.
Active managers: time to earn your keep
Despite players like Invesco removing trail commission from some of its funds, the relentless rise in annual charges has continued for actively managed funds. This has not been helped by the credit crunch wiping away assets. "The falling average fund assets for equity funds make it that much more difficult for industry average TERs to fall in 2009, particularly when no significant moves are being taken to cut actively managed fund fees," says Mr Moisson.
That said, Mr Moisson and Mr Traulsen agree that the pressure will increase on fund companies to justify fee levels in order to attract investors.
"Despite a historical low return on both asset classes and very large losses for investors, funds are still charging 1.6 per cent a year for losing investors' money and in many cases for doing worse than the index. I believe active managers will be under a tremendous amount of pressure to earn their keep - something they haven't done in the last few years. In this context, the entry of very cheap trackers increases the pressure even more," comments Mr Traulsen.
An increased focus on fees has already been witnessed in the funds of funds space, where fears over higher charges have been longer established and hence more actively addressed by these fund companies.
Leading on from this, Mr Moisson sees the area of 'funds of ETFs' as particularly interesting. "Rather than choosing the best managers or funds, which is the normal fund of funds selling point, these funds use ETFs as an asset allocation strategy. The use of ETFs should mean that the total costs to the investor are much more reasonable."
Another phenomenon has been the greater use of performance fees by a number of specialist active funds. The number is still small - but expect more innovation in this area.
According to Mr Moisson, of the around 40 open-ended funds in the UK that charge performance-related fees, more than half charge 15 per cent of net gains on their base fee, while just two - Hiscox Global Financials and SVM Funds Global Opportunities - charge 10 per cent. The remainder charge 20 per cent as their base fee, although all of the funds with performance fees use different accompanying structures such as fee caps, High Water Marks and hurdle rates.
"I like the concept of performance fees," says Mr Traulsen. "But active management fees are high because active managers are suppose to outperform the index. So if we see a performance fee attached to a fund, we want to see a substantially lower TER and AMC. It is also important to ensure the fee is structured well - managers need to benchmark against an index which reflects what they do."
Mr Traulsen says the ideal (and much fairer) cost structure would be "fulcrum fees", where fees go up if a fund outperforms, but go down by an equal proportion when the fund underperforms. While mandatory in the US, this charging structure has yet to take root in the UK.
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