What encompass ETFs’ fees, the cost comparison between ETFs and Mutual Funds, and the impact on investors’ returns
ETFs have a much simpler and cheaper all-inclusive cost structure than Mutual Fund. ETFs have no entry and exit fees (front-end and back-end load), and no requirement on initial and subsequent minimum investment.
Cost compounds. The mutual fund’s adverse fee charges to investors with less investment capital in comparison to institutional investors, has made ETF appealing to retail investors.
What costs encompass for active and index tracking funds?
Higher fees charged by active manual fund are used to compensate fund manager’s skills to outperform the benchmark index. For index tracking funds, ETFs and Passive Mutual Fund, where invest policies are to replicate the holdings and performance of a designated index, fees are used to measure investment companies’ ability to manage the portfolio efficiently.
The most representative and all-inclusive cost represent what it cost to invest in an ETF or Index tracking mutual fund is Total Expense Ratio (TER), or Ongoing Charges Figure (OCF), a new term for TER. It is an annual recurring percentage charge based on assets under management. TER or OCF represents two components mostly.
- Annual Management Charge (AMC) that is paid to fund manager, who is responsible for managing changes between index rebalancings, corporate actions (for example, dividend payment, or mergers and acquisitions) and investment rating decisions.
- A variety of operational costs, including administration, custody and audit fees, legal, regulatory and registration expenses.
Chart 1. Average, High and Low of the Fund Cost (TER %) by Assets Classes
Among over 2,000 European ETFs tracked by ETFEurope.net, it shows that Fixed Income and Equity ETFs have the lowest average TER, around 0.24% and 0.36% respectively. Lyxor Core Morningstar US (DR) UCITS ETFS and Lyxor Core Morningstar UK NT (DR) UCITS ETF has the lowest TER, 0.04%. In the Fund Screening page of ETFEurope.net, users can sort TER from the lowest to highest.
Chart 2. The Lowest Cost European Equity ETFs on ETFEurope.net
Both are index tracking, how different the costs are between ETFs and passive mutual funds?
The cost for ETFs is very straight forward, there are no front-end or back-end load fees when purchase or sell ETFs. There are no performance fees to incentives fund managers to out-perform the benchmark index. TER or OCF represents the all-inclusive cost of holding ETFs.
The cost of mutual funds is complicated with the creation of different share classes under the same fund. Each share class has different Ongoing Fund Charge (Similar to TER or OCF in ETFs), with different front-end or back-end load fees. Often the fee reduces as the initial investment requirement and/or subsequent investment requirement increases. The net result is that institutional investors with large investment appetite are rewarded with higher performance due to low fees, whereas retail investors with small investment budget is penalised by the high cost.
An example is iShares North American Equity Index Fund (UK), which has A, D, H, L, X, 5 share classes.
Chart 3. Multiple Share Classes’ Cost Comparison for iShares North American Equity Index Fund (UK)
Class A Shares
Class A share have the highest Ongoing Fund Charge and the highest Initial Charge. It is normally the default options for buying mutual funds that are sold either by financial advisors who work directly with investors or by issuing fund company. The initial charge, often called front-end load, is a one-off fee, paid by investors upon the purchase of the mutual fund. Typically, this fee is between 2.5% and 5.75%, usually split between the fund company and the advisor to incentive the promotion of the mutual fund.
Investors may not need to pay the entire Initial Charge. Fund companies often run special campaigns to lower or waive the initial charge. Initial Charge can also be reduced with large initial investment. Sometimes, investors can sign a letter of intent to commit certain amount of investment by a future date.
Class D Shares
Class D Share have relatively low Ongoing Fund Charge and no Initial Charge, meaning investors don’t have to pay the initial charge when they buy, or exit charge when they sell. However, D Shares aren’t available to everyone. Only certain retirement plans and brokerage firms will offer them.
Class X Shares
Class X share with minimum 10 million GBP initial investment requirement have nearly zero Ongoing Fund Charge. Such low fees are only available to institutional investors.
In summary, retail investors are already wiped out by 5%, upon putting money in the funds, and each year, get 0.5% less returns than institutional investors. Mutual Fund’s unfavouring of retail investors made the choice of ETFs appealing, which has a much simpler and cheaper fee structure.
To find ETFs equivalent to iShares North American Equity Index Fund, browse ETFEurope.net’s Equity Search Panel, select “North America”, and Click the TER header to sort ETFs from the lowest to highest cost. Quickly investors can identify two Vanguard FTSE North America UCITS ETF with only 0.1% TER, ticker VNRT traded in GBP and ticker VDNR traded in USD.
Chart 4. North America Focused ETFs Ranked by Cost from Low to High
What cost means to investors and why it is important to select low cost funds?
Presume underlying index returns 5% per annum, ETFs with 0.5% TER or OCF delivers 4.5% return to investors, whereas ETFs with 1% TER or OCF delivers 4%. This may not sound a lot, however, over 30 years’ time, investors purchased ETFs with 1% TER receive 13% less compared to ETFs with 0.5% TER. This differences exacerbate even more for ETFs with 2% TER, which under-perform by 35% compared to ETFs with 0.5% TER.
Chart 5. The Cost Impact on Investor’s Returns
Cost compounds, investors not just lose the small amount of fee differences, but also lose all the growth that money might have had for years into the future.
