How to pick a low-cost ETF

Paris-based ETF provider Lyxor has recently launched Lyxor Core Morningstar UK NT (DR) UCITS ETF (LCUK) and Lyxor Core Morningstar US Equity (DR) UCITS ETF (LCUS). These ETFs invest in US and UK equities and have charges of 0.04 per cent – the lowest ETF fees in Europe, undercutting rivals by at least 0.03 per cent.

ETFs used for core holdings, such as UK and US equity strategies, can be the most important funds in a portfolio. They are typically held longer than other funds and relied upon for consistent growth or protection. As investor demand for them has grown, their charges have gone down, but with numerous products to choose from it is important to be able to sort the wheat from the chaff.

How providers drive down costs

Firstly, you need to understand how providers can offer a product at such low prices, while bearing in mind that not all ETFs' charges will eventually fall to this level. Lyxor, for example, only offers two ETFs at this price which are part of its Core range.

UK and US equity trackers are two of the most popular strategies with Lyxor customers and investors more widely, giving Lyxor the confidence to keep prices lower on these products as they will always be popular.

Unlike some other ETFs, these funds and others in the Core range physically buy companies – so investors indirectly have ownership of the stocks. ETFs sometimes use a derivative swap to replicate an index, meaning they do not buy the companies in the index they track. This allows the ETF to experience the same changes in value as the index and can be more efficient than buying the securities in the index, but tends to be more expensive to manage.

Providers such as iShares, Vanguard and Deutsche Bank, which offers the X-Trackers funds, lend some of their holdings to other investors in return for a fee. Securities lending is relatively low risk and generates extra revenue for the ETFs and their investors, but can cost more to manage. So Lyxor's new funds will not do this.

"Simplicity has been the key," explains Adam Laird, head of ETF strategy at Lyxor. "These will be fully physical [replication] with no [derivatives] or securities lending. We wanted to make them as simple as possible."

Lyxor has also taken a slightly different approach with regards to the indices these ETFs track. The charges ETFs have to pay index providers for tracking their indices have been a huge barrier to lowering the cost of funds for investors. High-profile index providers, such as MSCI and FTSE Russell, charge relatively high licensing fees to use their products. So Lyxor is using ratings agency and index provider Morningstar for its new UK and US equity funds.

"Our job is to deliver the right performance at the right price," says Mr Laird. "And if there is a better way to do it using a different index, then we have to do it."

Low-cost consequences

But if Lyxor re-ignites an ETF price war – one that has already forced fees on some funds down to 0.07 per cent – investors should question whether it could affect quality. However, analysts seem satisfied about Lyxor's latest approach, and say that if providers have a lot of assets they should be able to do this too.

James McManus, investment manager at Nutmeg, says the latest price cut is long overdue as so far investors have not benefited as much from price cuts as providers have by growing business.

"There is no loss of quality in the products that are cheaper or where prices are being cut," he says. "There is no way of doing a stripped-back job – you either do it properly or not at all. It is less about a lack of quality and more about being competitive. Lyxor is not the first to lower costs with the emphasis on building scale and it will want to raise assets to make sure the products pay for themselves. Vanguard came into the European market with the same cost-cutting approach and it has paid off."

Hortense Bioy, director of passive fund research in Europe at Morningstar, says providers need scale in their funds and as a company.

"To make an ultra-low-cost product profitable, a firm needs to build scale and operate a very efficient business," she says. "With investment products, the proof is in the pudding. The firm must be able to deliver."

So as Mr McManus suggests, providers work on the basis that lowering costs will drive sales and give them the assets they need to make business profitable. If all ETF companies do this, it gives investors access to very low-cost products.

How to choose a cheap ETF

When choosing any investment product, cost should be one of a number of factors you consider. Low-cost ETFs tend to be relatively simple index trackers, so judging the quality of one against another can be difficult. However, there a couple of ways in which you can do this using metrics.

One of these is tracking difference, which shows the difference between the performance of an ETF and the index it tracks. Because of fees and trading costs ETFs tend to underperform the index they track, but there are some exceptions, as the table below shows. Several ETFs have beaten the index they track over three years and show a positive tracking difference. This is because they replicate the performance of the index using derivatives or lend securities, the revenue from which boosts their performance. But you should be comfortable with these approaches if you invest in one of these outperforming ETFs.

Tracking error, meanwhile, measures the accuracy with which an ETF rises and falls with the index it tracks, so uses more data points than tracking difference. It provides a more accurate view of how good an ETF is at tracking an index. The lower this figure is the better, with a 0 per cent tracking error implying perfection. But unlike tracking difference it cannot be negative.

As a general rule of thumb, ETFs that make their returns via a derivative swap rather than buying securities in the index they track are better at reducing tracking error. For example, Lyxor FTSE 100 UCITS ETF (L100) has a tracking error of 0.02 per cent.

Currency can also have an effect when and if an ETF provider hedges back into sterling.

Lynn Hutchinson, head of passive product research at wealth manager Charles Stanley, says investors should also consider attributes such as fund size. A smaller ETF will have higher trading costs which are passed onto investors in addition to the ongoing charge or total expense ratio. For example, recently launched Lyxor Core Morningstar UK NT (DR) UCITS ETF has a transaction cost, known as a trading spread, of 0.1 per cent. Larger ETFs can normally reduce this to around 0.03 per cent.

And the purchase of new shares in an ETF incur stamp duty of 0.5 per cent. A larger, older ETF is more likely to have existing shareholders willing to sell their shares on the secondary market, where stamp duty is not required.

Also balance the price of a fund with the quality of the returns you receive as there may be times when a more expensive product is a better choice.

But none of this takes precedence over selecting the ETF with the right exposure. "Investors should be looking at the index and seeing if it is the one they want," says Ms Hutchinson. "Quite often indices can be quite different."

Investors tend to be more comfortable with well known indices such as the FTSE 100 or FTSE All-Share for UK equities, and S&P 500 for US stocks. But it can be beneficial in terms of costs to try another index. For example, the Morningstar UK index which Lyxor Core Morningstar UK NT (DR) UCITS ETF tracks has 336 companies compared with 101 in the FTSE 100 and 638 in the FTSE All-Share. Similarly, the Morningstar US index has over 800 companies compared with 505 in the S&P 500.

"There is a wealth of information on the index an ETF tracks, so investors can look at the number of holdings and sector exposure," says Mr McManus. "The question is how wedded investors are to the brand. You can cut the equity market into different shapes and sizes, depending on the exposure you want. There should not always be a set framework for looking at markets and I am not convinced investors need to be tied to one index provider."

Tracking difference of core ETFs offered by larger providers