In last week's Autumn Statement Chancellor George Osborne announced the removal of stamp duty on purchases of exchange traded funds (ETFs) domiciled in the UK. But the change, which will take effect from April 2014, won't have a direct effect on UK investors. Or at least not yet.
That's because there are currently no ETFs domiciled in the UK. An ETF is a type of security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. The additional stamp duty borne by investors has made the UK a less attractive home for ETFs than other countries, causing fund houses to opt to domicile their funds elsewhere, where this tax is not applied.
If ETF providers did domicile their products in the UK, investors would pay 0.5 per cent more per trade. But because of this forthcoming change, they won't and Adam Laird, head of passive investments at Hargreaves Lansdown, says fund managers are likely to start domiciling their ETFs in the UK - although not immediately.
Stamp duty of 0.5 per cent does not sound like much, but in fact it would have a significant effect on your returns.
Take an investor who has £1,000 in ETFs that make on average 5 per cent return every year. If they switch every month and pay 0.5 per cent, instead of 0 per cent stamp duty, after a year they'd have £984.08 instead of £1,050 (a 6.7 per cent difference).
After three years, they'd have £961.66 instead of £1,157.63 if they were paying stamp duty - 20.2 per cent less.
And at the end of year five, they'd have £940.62 instead of £1,276.28 if they were paying stamp duty - 35.6 per cent less.
The other benefit of owning a UK-domiciled ETF would be that the Financial Conduct Authority would regulate it, and it would be covered by up to £50,000 per company by the Financial Services Compensation Scheme. ETFs that are domiciled elsewhere are covered by similar compensation schemes run by those countries. However, whether in the event of a melt-down those schemes would pay out to British investors is a grey area, according to Mr Laird, who recalls the Icelandic banking crisis when the British government had to bail people out.
Other costs that come with ETFs
As with other types of funds, the total expense ratio (TER) is often only part of the story when it comes to charges. As well as stamp duty, there are a number of charges you should be aware of if you've got ETFs in your portfolio.
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 about 0.3 per cent, making it more difficult for you to figure out how closely it's actually tracking its index.
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, costing several basis points.
Bid-offer spread: investors also need to watch out for the bid-offer spread on any ETF they are thinking of buying. 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.
Here's three examples of popular ETFs and their bid-offer spreads, taken on 6 December 2013. You'll see some are much wider than others.
The biggest FTSE 100 ETF
iShares FTSE 100 UCITS ETF (ISF) (TER 0.4 per cent, bid offer spread 0.05 per cent)
The cheapest S&P 500 Tracker
Vanguard S&P 500 UCITS ETF (VUSA) (TER 0.09 per cent, bid offer spread 0.1 per cent)
Cheap Emerging market ETF
HSBC MSCI Emerging Markets UCITS ETF (HMEF) (TER 0.6 per cent, bid-offer spread 0.28 per cent)
