There's a price war going on in the world of exchange traded funds (ETFs). In a bid to make funds look as cheap as possible, fund houses are slimming down total expense ratios (TERs) to make them leaner than ever before. In line with the trend, Vanguard has recently extended its range of cheap ETFs with a further four funds with ultra-slim TERs of between 0.15 and 0.29 per cent. But does this mean there are more good value funds for investors to put their money into?
ETFs are touted as the cheapest investments available for you to buy, but whether you get what you pay for when you buy the cheapest of the cheap is a matter for debate.
Cheap ETFs are cheap for a reason, argues Max King, investment strategist and multi-asset fund manager at Investec Asset Management. He says the difference between cheap ETFs and their more expensive counterparts is simple. Those carrying the most modest price tags rebalance less often and tend to track a smaller number of illiquid stocks. In other words, they don't track the indices they follow as well and therefore make worse investments.
But Hortense Bioy, ETF specialist at Morningstar, strongly disagrees. She says: "I don't think investors should be more wary of the ETFs with the lowest TERs than those with the highest TERs. The idioms 'it's cheap for a reason' or 'you get what you paid for' don't really apply to ETFs.
That said, investors should bear in mind that the TER is only part of the picture when it comes to costs. A TER can be misleading as it doesn't reflect the total cost of holding a fund. There are other less visible costs that investors should take into consideration."
And Deborah Fuhr, managing partner at ETFGI, also says you should be wary of TERs as they are not an accurate way of determining the true cost of an ETF. She points to fund houses which appear to have TERs of 0 per cent but have costs not included in the TER such as transaction fees - db x-trackers Euro STOXX 50 ETF is an example. She reminds us that most of the associated costs lie outside the TER when it comes to ETFs.
Some ETFs have a number of hidden costs that can eat into your returns and these include cheap funds. For example, 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. 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 they're actually tracking their indices.
Index, custodian and account service fees are also common costs that make funds more expensive than they appear. 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.
Funds also have to pay custodian and account service fees, neither of which are included in the TER.
Indices to track with cheap funds
Some indices are cheaper to track than others. The cheapest ones are those with the least volatility, according to Mr. King. He describes the FTSE 100 as a "wretched index" which is still 5 per cent lower than it was on New Year's Eve 2000, but says it's one of the easiest and cheapest for an ETF to track. The FTSE 250, on the other hand, has more than doubled over the same period, so, although investing in it would have been much more fruitful returns wise, the tracking would have been much more expensive.
But Mr King says that in any case, active funds find it easier to outperform the FTSE 250 index as there's more choice of stocks and the benchmark weights are lower than the FTSE 100. He recommends using cheap ETFs to cash in on bull runs over the short term rather than for long-term plays, where he says active funds are more appropriate.
We took five of the funds with the cheapest TERs you can buy on the London Stock Exchange and measured how well they track their indices. Or, in other words, how cheap they really are.
| Fund | Inception date | Tracking difference since inception | Tracking difference annual equivalent | TER | Is it really cheap? |
| HSBC S&P 500 ETF (HSPX) | 28/05/2010 | -1.06% | -0.29% | 0.06 | Trailing the S&P 500 by 0.29 per cent per year is pretty good as we've had some volatile markets since 2010. Since inception you would have seen around a 42 per cent return from the ETF and a 43 per cent return from the index. Tracking error looks very low too, suggesting that the methodology is correct and the low tracking difference should continue. |
| Vanguard S&P 500 (VUSA) | 23/05/2012 | 1.53% | 1.65% | 0.13 | The annual tracking difference here is quite large. This could be due to the differing rates of withholding tax in the US and the UK. However, such outperformance is not guaranteed, and technically should be as unwelcome as underperformance from a tracker fund. The low tracking error is encouraging, but as the fund only launched a year ago, it might not be a reason to have complete faith in it just yet. |
| VANGUARD FTSE 100 ETF (VUKE) | 31/05/2012 | -0.18% | -0.20% | 0.15 | All of these numbers seem very reasonable, which is to be expected with a large liquid market like the FTSE 100. |
| Vanguard UK Government Bond (VGOV) | 23/05/2012 | -0.36% | -0.39% | 0.16 | The gilt market is so large and liquid you'd expect this fund would be very close in terms of tracking error and difference, but quantitative easing may have distorted things slightly. With UK bonds yielding so little, a 0.36 per cent difference has more relative impact than on an equity tracker. |
| HSBC EURO STOXX 50 ETF (H50E) | 06/10/2009 | 1.48% | 0.42% | 0.34 | This positive tracking difference is likely to have come from stock lending. The ETF has been running since 2009, and European stocks have had a turbulent time since then – and there has been a lot of appetite for borrowing to short the market. Equally, the volatility probably accounts for most of the large tracking error, especially as with only 50 stocks, concentrations will be proportionally higher than in the S&P 500, for example. A large move before rebalancing day would have more impact. A tracking error of 0.34 is towards the higher end of the range we'd like to see, but it is still within a comfortable range. |
| Source: Seven Investment Management | |||||
