The indexing landscape has changed. Investors have four options when considering how to implement index mandates: index mutual funds (IMF), Exchange Traded Funds (ETFs), derivatives or separate accounts.
In this article, we focus on ETFs and when and why it might potentially be more efficient from a cost perspective to use an ETF instead of an alternative wrapper. However, the foremost factor an investor should consider before using an ETF, is whether its exposure is in line with the target. Only then it would make sense to consider a cost comparison between IMFs and ETFs.
The total cost of ownership (TCO) framework allows for comparison between different investment vehicles despite different charging structures. The TCO framework considers the costs to purchase, the cost to own, and the cost to sell an investment. It is a more rounded way of evaluating the most cost-efficient vehicle and a better reflection of true costs.
The TCO framework shows the potential role of ETFs in the portfolios of institutional clients. In asset classes with high underlying transaction costs, the use of large liquid ETFs can help to reduce the TCO for clients.
The TCO framework explicitly incorporates the costs of entering and leaving a specific position. Trading costs of investment solutions have been part of Kempen’s due diligence and monitoring processes for many years. We hope to highlight the importance of using the TCO framework to facilitate implementation decisions. It is however noteworthy that the TCO framework is stylized and that benchmark differences, ESG considerations, presumed quality of portfolio management and other factors will impact the decision regarding the optimal implementation vehicle.
In order to show the importance of using the TCO framework when making an investment decision, we carry-out a two-fold analysis:
- To demonstrate a worked example for Emerging Market Equities (EME), USD Emerging Market Debt (EMD) and ¬£ Investment Grade Credit (IGC) ETFs where the TCO is calculated for different holding periods of up to two years
- To compare the results in a. above with the corresponding TCO of IMFs
Based on the results of our analysis, we draw two important conclusions. Both for strategic and tactical investment implementation decisions, investors should compare costs in the framework of TCO. The TCO captures extra costs that are missed by the TER such as bid/offer spread and gains from security lending. These costs are an inevitable part of running any type of investment fund and should be considered by investors. Looking solely at the TER is misleading because the product with the cheapest TER is not necessarily the cheapest product you can buy.
The TCO is a helpful tool to decide on the implementation vehicle. Kempen evaluates funds (including ETFs) on a large range of characteristics including costs of entering and selling. The TCO framework can help to take TCO efficient decisions regarding the implementation of allocation decisions. A good example of this is the relatively low costs associated to implement sterling investment grade credit, by accessing Sterling IGC with a total transaction cost of 9bps, versus c40bps using the traditional route of a pooled fund, via iShares Core Sterling Corporate Bond UCITS ETF (SLXX). The TCO framework can be extended to different investment vehicles such as futures and other derivatives. As we show in this analysis, it can also be used to capture both the securities and unit lending impact in the form of better fund performance and net return to investors. Securities lending returns typically vary by asset class and upon the underlying demand for securities.
This fits in well with Kempen’s cost transparency policy where we advise trustees to understand all sources of costs (size, investment strategy, etc.) and investigate what is already available to compare and contrast. Using the TCO approach can improve cost transparency and help investors make better decisions.
Our results show that for the asset classes EME, IGC and EMD, ETFs offer significant cost efficiency
with respect to index mutual funds studied here. This applies both in the strategic and tactical space for EME and IGC and for EMD more in the tactical space, without trading off return and risk. Hence, our clients can achieve material cost savings.
We recommend to consider ETFs by default for indexed portfolio construction of these asset classes, recognizing that other factors such as hidden market impact and benchmark differences can play a role when selecting a fund for a client.
This article has been abridged from a longer white paper entitled Total Cost Ownership: A framework for ETFs, authored by Kempen Capital Management’s Maya Beyhan. The full paper can be accessed here: https://www.kempen.com/-/media/News-and-Knowledge/Whitepapers-en-Artikelen/Total-Cost-of-Ownership_ETF-Cost-Structure_External.pdf