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Best low-cost core ETFs for your portfolio

Providers have been cutting the costs of exchange traded funds and launching basic low cost ranges, but these may not always be the best option.
December 3, 2014

Earlier this year exchange traded fund (ETF) provider iShares cut the cost on a number of its funds, as well as launching a new one, to create what it calls its Core Series of low cost ETFs. The company said the aim of this range is to be used as the foundation of a portfolio.

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It followed Deutsche Asset & Wealth Management's expansion of its range of Core-ETFs with the launch of a physical replication fund, MSCI USA Index Ucits ETF (XDUS).

Other ETF providers with funds listed in London also offer relatively low cost ETFs covering major markets. Vanguard, for example, offers a FTSE 100 ETF (VUKE) with an ongoing charge of 0.09 per cent.

"The launch of core ranges has been a direct response to the arrival in the European marketplace of ultra low cost providers such as Vanguard," says Jose Garcia-Zarate, senior analyst, passive strategies research at Morningstar. "We have seen most ETF providers cutting costs on ETFs tracking very popular plain vanilla benchmarks. There is a clear competition going on among providers for this slice of the market focusing on products that many investors would like to have in their portfolios."

Increasing competition means if you shop around you should be able to find ETFs covering mainstream areas for a reasonable level of fees. However, while charges are an important consideration when buying funds, they are not the only one, and buying one of these low cost ETFs might not be the best option for all investors.

As well as the charge, another cost ETF investors have to factor in is the bid-offer spread, and this is especially important if you intend to trade regularly rather than buy and hold. Bid-offer spread is the difference between the buy and sell price of an ETF (or other listed share). Although it is not a charge it's a cost of trading.

In some cases an ETF has a lower bid-offer spread but higher charge, and for traders who only hold the ETF for the short term, this may be a better option than a low cost ETF with a wide spread, according to Adam Laird, head of passive investments at Hargreaves Lansdown.

As an example, he has compared iShares' low cost Core ETFs with its more expensive versions tracking the same indices, and considered the ongoing charge against the bid offer spread on 27 November, to work out which time horizon each one is better for. So with the FTSE 100 trackers if your investment horizon is less than one year and one month, you're better off buying the higher annual cost iShares FTSE 100 Ucits ETF (ISF) than iShares Core FTSE 100 Ucits ETF (CUKX) at that time. However, with regard to the S&P 500 funds in the US, you benefit from the lower annual charge of iShares Core S&P 500 Ucits ETF (CSP1) after six and a half months.

 

FundCodeOngoing charge (%)Average 5 day spread (%)*Break even point
iShares Core FTSE 100 Ucits ETFCUKX0.10.361 year and 1 ½ months
iShares FTSE 100 Ucits ETF (Inc)ISF0.40.03
iShares Core S&P 500 Ucits ETFCSP10.070.216 ½ months
iShares S&P 500 Ucits ETF (Inc)IUSA0.40.04

Source: Hargreaves Lansdown, *Bloomberg as at 27 November

 

"You can work out the spread on any ETF by looking at the quoted buy and sell price on the stockbroker's platform," says Mr Laird. "On Hargreaves Lansdown's website, we quote an indicative spread on each ETF's fact sheet. A big caveat, however, is that spreads aren't fixed, they change throughout the day and aren't predictable. The spread could be higher or lower on the day you trade."

So you need to consider how you are going to use your ETF, eg. buy and hold or frequent trading, and also carefully check costs and spreads at the time you intend to buy. When checking the charge, look to see what the ongoing charges figure is in the latest Key Investor Information Document (KIID) on the provider's website, because these change over time, too.

Liquidity – how easy it is to buy and sell an ETF – can affect the bid/offer spread. If an ETF is not easy to trade it may widen the bid/offer spread. This can be a problem for small funds, so size is a consideration.

Tracking error is also important, because if an ETF does not track its index closely you are losing out on potential return.

Other reasons why you might not want to go for a low cost core ETF is if you want to invest in something more esoteric: typically these funds only cover major markets and mainstream assets such as bonds and equities.

An important consideration is whether you are an income or growth investor, because not all of the low cost core ETFs offer options for both. With iShares Core Series, for example, the equity funds don't do dividend distributions – only the two bond funds do this. So if you want income you will need to look elsewhere.

Meanwhile db X-trackers FTSE 100 Ucits ETF (XDUK), db X-trackers MSCI USA Index Ucits ETF (XD9U) and db X-trackers MSCI World Index Ucits ETF (XDWD) also don't pay dividends, while db X-trackers DAX Ucits ETF's (XDDX) income share class is listed in London, but its accumulation share class is not.

 

Best low-cost funds

For low-cost core exposure, Mr Laird says the iShares Core Series does a good job.

This suite of nine ETFs includes some IC Top 50 ETFs such as iShares FTSE 100 Ucits ETF which aims to track the FTSE 100 Index of the UK's leading companies. The ETF buys shares in the FTSE 100, as opposed to using a swap, and has an ongoing charge of 0.1 per cent.

He also likes Vanguard's range of ETFs, which have charges between 0.07 per cent and 0.29 per cent. It includes IC Top 50 ETF Vanguard FTSE Japan Ucits ETF (VJPN), which is one of the lowest cost Japan equity ETFs listed in London with an ongoing charge of 0.19 per cent. It aims to track the performance of the FTSE Japan index using physical replication. Its base currency is dollars and it distributes the income quarterly.

The cheapest Japan ETF is db X-trackers Nikkei 225 Ucits ETF (XDJP) with an ongoing charge of 0.09 per cent and which also uses physical replication.

IC Top 50 ETF Vanguard FTSE Emerging Markets ETF (VFEM), meanwhile, has tracked its index, FTSE Emerging markets, well and has an ongoing charge of 0.25 per cent, making it one of the cheaper emerging markets options available on London Stock Exchange. It uses physical replication – ie it buys shares in the index it tracks.

Amundi ETF MSCI Emerging Markets Ucits ETF (AEEM) is even cheaper with an ongoing charge of 0.2 per cent, but uses synthetic replication.

Mr Gilligan likes the Vanguard S&P 500 ETF (VUSA). "This is quite a difficult index for active managers to outperform and it is also very diverse, for example, the largest holding, Apple, only accounts for 3.6 per cent of assets."

It has an ongoing charge of 0.07 per cent.

You could also consider an open-ended tracker fund, some of which also have low prices like core ETFs. These are simpler in terms of their construction than ETFs, and providers such as HSBC and Vanguard offer low cost ranges. Vanguard's funds, for example, charge between 0.08 and 0.38 per cent, though some also levy a purchase fee to compensate for Stamp Duty Reserve Tax related expenses.

Mr Sleep says that open-ended tracker funds can also be cheaper to buy and sell via online platforms. "I think ETFs and open-ended tracker funds are very comparable," he says. "I think the thing that swings it for many investors is the brokerage fee that their online platform may charge when buying an ETF. In my experience the brokerage fee for an ETF purchase can be as high as £10 to £15 per ETF, whereas there is not usually a brokerage fee for a fund. Some tracking funds have a purchase cost to cover costs such as UK stamp duty, but you usually find that there is an invisible purchase cost for an ETF also, which similarly covers costs like stamp duty."

 

Choosing a low-cost ETF

When choosing a low cost ETF you should consider two questions:

 

What index does the ETF track?

Does the index give you the exposure you need to meet your investment goals? You should also consider if the index itself is currently cheap, and also how varied it is: is it only made up of a few constituents or heavily concentrated on certain sectors? For example, Mick Gilligan, head of research at Killik & Co, says he is not keen on ETFs that track the MSCI Emerging Markets Index because financials account for more than a quarter of its components, and resources account for more than 16 per cent.

You should also consider your risk tolerance: basic equity ETFs track mainstream indices so if you cannot cope with the volatility of equity markets then they may not be suitable.

There are some bond options available which are in theory lower risk, but Mr Gilligan doesn't recommend bond ETFs because passive bond funds track indices where the largest components are the most indebted companies or countries, in contrast to equity indices where the largest components are the largest and maybe some of the strongest companies. He also doesn't see much value in Gilts at the moment.

 

How does the ETF replicate its index?

Some ETFs buy some or all of the shares in the index they track. But others, known as synthetic ETFs, get the returns via a swap with a counterparty, usually an investment bank or insurance company, which pays the ETF the returns of the index it is tracking, often in exchange for the returns of a collateral basket held by the ETF.

It can be cheaper to set up a swap than buy all the shares in an index, and regularly rebalance the ETF's portfolio. But the major risk is that the swap counterparty defaults, say, because it has become insolvent and is not able to honour its obligation. But in recent years synthetic ETF providers have taken a number of steps to mitigate this risk.

Some providers such as ETF Securities, iShares and Source use multiple swap counterparties so if one fails then there are others to fall back on. And if a synthetic ETF is compliant with fund legislation known as Ucits (Undertakings for Collective Investment in Transferable Securities) it is obliged to hold collateral worth at least 90 per cent of the value of its assets to mitigate losses.

"Check if the ETF you are thinking of investing in uses derivatives and how they are used," says Mr Laird. "These can be the cheapest way to replicate an index but you should be aware of their intricacies."

Synthetic replication can be more appropriate in certain areas that are hard to replicate such as emerging markets, but Mr Gilligan feels that for mainstream indices such as the FTSE 100 there is not a need to consider synthetic ETFs as there are many physical fund choices.

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If the ETF uses physical replication - buys some or all of the shares in the index it tracks - then you should check if it lends these securities. This can bring revenue in helping the ETF to track its index more closely, or even slightly outperform it, and reduce costs for investors.

But it also adds in counterparty risk - the risk that the borrower does not return the assets. But ETFs may take precautions against this such as holding assets worth the value of the securities lent out.