If you bought a £3 'all-in' meal deal for lunch you wouldn't expect to take it to the till to be charged an extra 50p for individual bits of salad inside your sandwich. But in fund land, there is no such thing as a single number that covers all the costs involved in buying and owning them. This means providers can throw in all sorts of extra hidden costs.
Typical active fund manager fees are weighty at around 1.5 per cent, but exchange traded funds (ETFs) are simpler products that track markets and have no need to pay expensive fund manager fees. As a result, they come with much lower price tags, some boasting fees as low as 0.07 per cent. However, the problem with ETFs is many of them are not as cheap as we are led to believe.
All funds have to disclose a total expense ratio (TER) which is supposed to be an indication of how high the costs associated with ownership are. These costs consist primarily of management fees and additional expenses such as trading fees, legal fees, auditor fees and other operational expenses
But these sometimes don't reflect the true costs of owning ETFs. A number of providers show a figure they call the 'Total Cost of Ownership', which includes a range of internal costs (including the TER) so is more accurate. But in many cases, this still falls well short of the true costs.
Many come with hidden charges that mean providers can charge you several times more than the cost indicated by the TER. And Ursula Marchioni, director of investment strategy at iShares, says the total cost of ownership of ETFs is technically "limitless".
This means in the worst-case scenarios, you may actually be paying as much for your 'bargain' ETF as you would expect to pay for any of the actively managed funds in your portfolio. Many actively managed funds are riddled with hidden charges you might not know about, too, so the ETF industry is simply conforming to a general lack of transparency in funds.
If ETF investors get performance that mirrors the index they want to track, hidden costs may be a secondary issue. However, all costs eat into returns so it is important to look at the ETF's prospectus to make sure you are happy.
Peter Sleep, ETF analyst at Seven Investment Management, points db-x Tracker's Equity Strategies Hedge Fund Index UCITS ETF (XHFE) as an example of such a product where actual costs are higher than the stated headline figure.
The factsheet states a "maximum all-in fee" of 0.9 per cent or 90 basis points (bps). So you'd naturally assume that means there are no other costs involved whatsoever.
Upon closer inspection, the hidden costs are significant. Not included in the "maximum all-in fee" are an assortment of costs buried in the 773 page prospectus: custodian and account service fees (0.08 per cent), index fees paid to DB (0.15 per cent), risk monitoring fees (0.5 per cent) and then on top of that, the hedge fund advisers are paid between 1 and 2 per cent with a 15-20 per cent performance fee on any profits.
Mr Sleep said: "The term 'maximum all-in fee' really stretches the English language in this case."
But a spokesperson at db-x trackers said not all the costs involved are "appropriate" for inclusion in the fact sheet, and argued the fund's total cost of ownership is "in line" with other hedge fund-of-funds products.
Elsewhere, Credit Suisse's CSI 300 ETF (CCSI) which has a net expense ratio of 0.5 per cent that does not include a 122bp 'swap fee', listed elsewhere in its documentation, and iShares Barclays Emerging Market Local Government Bond ETF (SEML) tracks a bespoke benchmark which has a 7bps a month “trading cost” deduction. Mr Sleep says this does not have an economic impact on the fund but makes its tracking error look better.
Hidden costs that drain your funds
Not all ETFs come with hidden costs, but these are just some of the add-ons you could be forking out for without knowing it if you're an ETF investor.
1) Tax cushioning
Funds tracking foreign indices have to pay withholding tax, which is equivalent to 30 per cent of the dividend. This is something that has to be claimed back manually by signing a form, but some ETFs assume this form has not been signed and build this into their benchmarks. Simply, this makes them look better because their performance is cushioned by up to around 0.3 per cent, making it more difficult for you to figure out how closely it's actually tracking its index.
2) Index, custodian and account service fees
Funds have to pay to track indices and they take this straight out of your returns. Some indices are more expensive to use than others and cost several basis points.
3) Funds also have to pay custodian and account service fees.
Bid-offer spread
Investors also need to watch out for the bid-offer spread on any ETF they are thinking of buying. The bid refers to how much you can sell your security for and the offer price is the lowest point that you can buy at. The difference between them is the bid-offer spread, and it always costs more to buy than sell. This difference allows market makers to make money directly from you, the investor. Funds with wide bid-offer spreads eat away at more of your returns. These tend to be in esoteric and illiquid markets such as emerging markets, rather than the US or the UK. The bid offer spread can cost you well over 100 basis points for funds in the most difficult markets.
ETFs with a tight bid-offer spread (at 10am on 28 February)
| ETF | Bid | Offer | Spread (%) | TER |
| Amundi FTSE 100 | 44447 | 44493 | 0.10% | 0.25% |
| Vanguard FTSE 100 | 29.675 | 29.705 | 0.10% | 0.10% |
| iShares S&P 500 USD | 15.12 | 15.13 | 0.07% | 0.40% |
| Amundi DJ EuroStoxx 50 - Paris | 46.8 | 46.82 | 0.04% | 0.15% |
| Lyxor S&P 500 USA USD | 15.39 | 15.4 | 0.06% | 0.35% |
ETFs with a wide bid offer spread (at 10am on 28 February)
| ETF | Bid | Offer | Spread (%) | TER |
| CS CSI 300 | 7033 | 7133 | 1.42% | 0.50% |
| RBS Frontier Markets | 48.19 | 49.11 | 1.91% | 0.90% |
| Pimco EM Debt in LCY | 107.54 | 110.6 | 2.85% | 0.60% |
| DB CSI 300 | 8.455 | 8.5525 | 1.15% | 0.50% |
| db S&P Select Frontier Markets | 663.25 | 670.25 | 1.06% | 0.74% |
Source: Seven Investment Management
