The true costs of ETFs

Rebecca Hampson

There are some pretty exciting characteristics about ETFs; the on-demand liquidity, the ability to trade intraday, the visibility and the low costs - and it is probably the latter that gets most people's attention.

These low total expense ratios (TERs) as they are often known, although management fee or all-in fee are also used, have been driven down in recent years by the so-called ETF price war.

Starting in the wake of the financial crisis with a battle between physical ETF vs. synthetic ETF providers, the ETF landscape as we now know it has been helped along by several other factors - Vanguard entering the market with their low fees in 2012, the US market's use of physical ETFs, and the synthetic model not working in a post 2008 world.

It has seen the cash come pouring in with record breaking flows over the last few years - the European market now boasts assets of over $800bn and globally the figure is in excess of $4tn.

But it hasn't always been this way and only since 2012 have providers been forced to slash their fees, helping drive huge flows of money into ETFs. This rich investment landscape has seen an increasing number of new entrants to the sector.

For example, since 2012 the SPDR S&P 500 ETF (SPX5) has been reduced from 0.15% to 0.09%, while even Vanguard lowered its fees with its VUSA/VUSD going from 0.09% to 0.07%. Other ETFs have had a haircut, such as Vanguard's FTSE 100 ETF (VUKE), which had a TER of 0.10% in 2012 now costs 0.09% and the iShares FTSE 100 ETF (ISF) TER was cut from 0.40% in 2012 and now costs 0.07%.

As an over view, data from ICI shows that the average cost of an equity ETF in 2009 was 0.34%, in 2016 it had dropped 32% to 0.23%.

There are also no signs that the price war is slowing. Last year iShares cut the fee of its S&P500 ETFs (IUSA) from 0.40% to 0.07%, bringing it in line with Vanguard's fee for the equivalent ETF. More recently, last October Deutsche Bank slashed the expense ratio of its Xtrackers USD High Yield Corporate Bond ETF from 0.25% to 0.20% making it nearly half the price of the equivalent funds from BlackRock and State Street.

Performance has also been good; the iShares S&P500 (IUSA) returned 17.99% last year. To put this in perspective, the average hedge fund returned 8%, according to eVestment.

The ETF sector is now one of the biggest sectors by assets and part of this success has been down to their ability to trade intraday, liquidity, transparency and of course, these low costs.

But when things are too good to be true, it's often because they are. I am not here to slam ETFs, they are a great product, but in my mind the cost of investing in an ETF does not stop at the total expense ratio. In fact, there can be several other costs when it comes to investing in ETFs that can start pushing the price up.

Firstly, the trading fees. On UK platforms there is typically a fee per trade, on average, it's around the £10 mark. If you're only investing small amounts this cost can add up, especially if you're trading more than once a year. The cost to trade on the platforms can range from 0-£70 a trade depending on where and how you are trading. It raises the question whether, as a buy and hold investor, a cheaper index tracker is a better option?

Secondly, the ability to trade can become costly. The platforms are where ETF trading happens. Often it is done by a broker because many of the platforms don't have direct relationships with the London Stock Exchange or their own broking capabilities.

Over the last two years trading platforms have re-structured their fees with many now offering it on a percentage of assets, for example for 0-£1m invested could mean a platform fee of 0.20%. The platform cost can now range from 0-0.65%, depending on how much is invested.

Thirdly, the cost of advice. Some platforms offer execution only services, meaning advice is not available while others offer advice as part of the service or a tag on. While this advice can often be included using a separate adviser can cost up to 3%.

Fourthly, the model portfolio fees. If you want your ETF wrapped up in a model portfolio this will also cost you. Many platforms offer their own ones, but discretionary fund managers and advisers also offer them on some platforms. Model portfolios usually charge a service fee, it's around 0.1%, but can be cheaper or more expensive depending on the platform.

If you add these up the cost of investing in ETFs can get quite pricey. When taking an average of all these costs, adding one trade a year based on an ETF costing 0.07% it ends up at 0.62%, if you add in an adviser fee it is 3.62%, compared to an actively managed equity portfolio which costs around 0.52% it's something to be aware of.

There is little doubt that ETFs are good value, but it's important not to be blinded by the dazzling cut price fees that you miss some of the other costs that can exist alongside them.

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